CORPFIN 7040: Financial Institutions Management II

CORPFIN 7040: Financial Institutions Management II Semester 1 – 2020 Problem Set

Due date: Coverage: Value:

Friday 5th June 4pm Lectures 3-9 30% of the overall assessment

Instructions: 1. Answer all questions below. 2. These problems may be attempted individually or in groups of two, three or four students. Students are not required to come from the same tutorial. 3. You must register your group on myuni. 4. You must also submit a soft copy of your problem set and all required spreadsheets online. Further details will be provided closer to the submission date. 5. Answer all questions as concisely as possible. 6. The presentation of your answers is important. Poorly presented work may result in loss of marks. 7. Any suspected plagiarism will be severely punished. This includes any group that submits copied work or any group that allows their work to be copied. 8. You must acknowledge any external material you use in your answers, e.g. material from websites, textbooks and academic journals. 9. All queries for this problem set should be directed to Dr Tariq Haque (Email: tariq.haque@adelaide.edu.au). In general, you should make and clearly state any assumptions necessary to solve the problems. LAST UPDATED ON 13TH MAY 2020 2 Grading of problem set Each problem in the problem set will be marked out of four as follows1:

Mark

Requirement

4

A perfect understanding of the concepts being tested which includes the following: (i) A concise well-worded answer, written in the group’s own words, and which also contains appropriate and accurate referencing; (ii) Well chosen examples that have been developed by the group that are directly relevant to the concepts being tested (iii) Accurate and appropriate calculations (if that is required) (iv) Very strong evidence that the group clearly understands the concepts being tested

3

A good understanding of the concepts being tested which includes the following: (i) A well-worded answer, written in the group’s own words, and which also contains appropriate referencing but which could be expressed more concisely; (ii) Examples have been developed by the group that are relevant to the concepts being tested but better examples could have been chosen. (iii) Calculations performed are mostly correct with some minor errors (iv) Reasonably strong evidence that the group understands the concepts being tested

2

An adequate understanding of the concepts being tested which includes the following: (i) An answer, written in the group’s own words, containing appropriate and accurate referencing but the structure of the answer could be improved significantly; (ii) Examples have been developed by the group that are relevant to the concepts being tested but the relevance is not well explained by the group (iii) Calculations performed are generally correct but may contain important errors (iv) Some evidence that the group understands the concepts being tested

1

A poor understanding of the concepts being tested which includes the following: (i) A poorly structured answer which contains inaccurate or no referencing; (ii) Examples have been developed by the group that are loosely relevant to the concepts being tested but the relevance is not at all explained by the group (iii) Calculations performed contain a significant number of important errors (iv) Limited evidence that the group understands the concepts being tested

0

A very poor understanding of the concepts being tested which includes the following: (i) A very poorly structured answer which contains inaccurate or no referencing; (ii) Examples have been developed by the group that are not relevant to the concepts being tested (iii) Calculations performed contain too many important errors (iv) Very limited evidence that the group understands the concepts being tested

1 Note: Half marks may be awarded, e.g. 3.5 out of 4. Also a grade of 0 out of 4 can be awarded for work that has been plagiarized (e.g. work that has been plagiarized from the internet or other sources or from other groups). Note that any group that allows its work to be copied will also receive 0 out of 4. LAST UPDATED ON 13TH MAY 2020 3 Lecture 3: 17/3/2020 Problem 1 (i) From the internet, download the annual reports for 2017, 2018 and 2019 for the Big 4 Banks in Australia:

Commonwealth Bank of Australia (CBA) Australia and New Zealand Banking Group (ANZ) National Australia Bank (NAB) Westpac Group (WBC)

(ii) For each of these banks and for each year, calculate the following ratios: Return on Equity (ROE) Return on Assets (ROA) Equity Multiplier (EM) Profit Margin (PM) Asset Utilization Ratio (AU) (iii) Explain, in your own words, how you would interpret each of the ratios above. Then go to: https://www.apra.gov.au/quarterly-authorised-deposit-taking-institution-statistics and download historical data for these ratios for the major banks in Australia. (iv) Hence explain how the Big 4 Banks have performed with respect to each of these ratios for 2017-2019 (compared to the historical ratios). Problem 2 In lectures, we discussed that if the maturity of assets exceeds the maturity of liabilities, then an increase (decrease) in interest rates will cause the value of assets to fall (rise) by more than the value of liabilities. In lectures, we looked at the spreadsheet on myuni (Go to ‘Modules’ > ‘Spreadsheets Used in Lectures’ > ‘Lecture2Examples.xlsx’) and looked at a numerical example to illustrate this fact. Suppose you are trying to use this spreadsheet (Cells A1: G16) to find the market value of fiveyear loans for CBA and the market value for one year deposits issued by CBA. (i) What is the interest rate on five-year loans issued by CBA? (ii) What is the interest rate payable by CBA on one-year deposits? (iii) What is the discount rate that you would use in cell B1 to do this valuation? (iv) What do you think are the limitations of this spreadsheet model? (v) Can this model be used to find the market value of equity for CBA? END OF LECTURE 3 PROBLEMS LAST UPDATED ON 13TH MAY 2020 4 Lecture 4: 24/3/2020 Problem 3 Consider Lecture 3 Slide 41 (reproduced below): (i) Explain why the duration of deposits is equal to 0 years in the table above. (ii) Provide an example of how: a. The duration of short-term certificates of deposit can be 0.4 years b. The duration of long-term certificates of deposit can be 2.5 years c. The duration of liquid securities can be 0.5 years d. The duration of investments can be 3.5 years e. The duration of fixed rate loans can be 2 years (iii) Explain why floating rate loans have a low duration (0.5 years in the example above) even though the maturity of the floating rate loans could be very high (for example a 30-year floating rate home loan). Problem 4 In discussing the maturity model and the duration model, we talked a lot about the market value of equity.

(i) (ii) (iii)

What is meant by the market value of equity? What does it mean when the market value of equity is negative? Give examples of shocks that might cause the market value of an FI to become negative (whereas it was positive before the shock)? What factors could reduce the likelihood of an FI’s equity turning negative?

(iv)

END OF LECTURE 4 PROBLEMS LAST UPDATED ON 13TH MAY 2020 5 Lecture 5: 31/3/2020 Problem 5 Consider the following lecture notes example: (i) Now consider the annual financial statements of Commonwealth Bank of Australia for 2019 (that you used in Problem 1). What is the value of assets for CBA using this data? Provide a breakdown of these assets also (e.g. value of home loans, value of business loans etc). Using these figures (and other information, as necessary), estimate the duration of assets for CBA. (ii) What is the value of liabilities for CBA? Provide a breakdown of these liabilities (e.g. short-term deposits, longer-term deposits, bonds issued). Using these figures (and other information, as necessary), estimate the duration of liabilities for CBA. (iii) What is the value of equity for CBA? (iv) What do you think is the current level of interest rates in Australia? You may need to do some research on the internet about this. (v) What do you think is a reasonable estimate for a possible change in interest rates in Australia? Again, you may need to do some research on the internet about this. (vi) Using the spreadsheet (Go to ‘Modules’ > ‘Spreadsheets Used in Lectures’ > ‘Lecture4Examples.xlsx’> ‘Slide 107’), input your assumptions above to estimate how much the market value of equity of CBA might change as a result of an interest rate shift. Problem 6 In lectures, we derived the following equation: (1 R) R E D D k A A L This equation assumes that interest rates are the same for assets and liabilities and that the change in interest rates is the same for assets and liabilities. LAST UPDATED ON 13TH MAY 2020 6 (i) What would be the formula for the change in the market value of equity if we assume that interest rates are different for assets and liabilities and that the change in the level of interest rates is different for assets and liabilities? (Hint: You may need to introduce new notation for the: interest rate on assets; the interest rate on liabilities; the change in interest rates for assets; the change in interest rates for liabilities) (ii) Using this formula, adjust the spreadsheet model on myuni (Go to ‘Modules’ > ‘Spreadsheets Used in Lectures’ > ‘Lecture4Examples.xlsx’> ‘Slide 107’) and use this adjusted model to estimate the change in market value of equity for CBA as a result of a possible interest rate shock. Problem 7 Consider Chapter 6, Q23 of your textbook (which was discussed in Tutorial Questions). Consider using a repricing gap model for the bank in this question. (i) Create a similar table to the one below (which is from the lecture notes example):

Assets

Liabilities

Gaps

CGap

1 day

$10

$40

-$30

-$30

1 day to 3 months

25

50

-25

-55

3 to 6 months

50

60

-10

-65

6 to 12 months

30

35

-5

-70

1 to 5 years

70

5

+65

-5

Over 5 years

10

5

+5

0

$195

$195

0

(ii) Calculate the change in net interest income for each bucket assuming a 1% increase in interest rates for all assets and liabilities (when they are repriced). (iii) Calculate the change in net interest income if all assets and liabilities that can be repriced within the next year are subject to a 1% increase in interest rates. (iv) Explain carefully whether the problem of runoffs is relevant for this bank. END OF LECTURE 5 PROBLEMS LAST UPDATED ON 13TH MAY 2020 7 Lecture 6: 7/4/2020 Problem 8 Go to https://markets.businessinsider.com/bonds which gives data on government and corporate bonds for different countries. Using this database, select one corporate bond, with approximately one year to maturity and a positive yield to maturity, from each of the following credit ratings and note that yield to maturity (which is equivalent to k in the lecture notes):

Aaa

A1

Baa1

Baa3

Ba1

Ba3

Caa1

(If corporate bonds with the listed ratings do not exist, you do not have to analyze any bonds for that rating). Then choose a value for i, the risk-free rate on a one-year government security (you must carefully choose and justify this value. Relevant data does appear on the same website if you choose the “Government” option). Then, produce a graph of 1-p, the probability of default, versus