Reference no: EM131803490

A financial institution has the following market value balance sheet structure:

Assets                                                                                    Liabilities and Equity

Cash            $1,000                                                             Certificate of deposit              $10,000

Bond           $10,000                                                           Equity                                        $1,000

Total assets $11,000                                                         Total liabilities and equity      $11,000

a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year?

b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?

c. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why?