Chapter 5

Managing Interest Rate Risk: Economic Value of Equity

Multiple Choice

1. EVE analysis: is essentially a _____________ analysis.

a. profitability
b. quality
c. liquidity
d. liquidation
e. earnings
Answer: d

2. Duration gap analysis:

a. applies he the concept of duration to the bank’s entire balance sheet.
b. applies he the concept of duration to the bank’s entire income statement.
c. applies he the concept of duration to the bank’s retained earnings.
d. indicates the difference in the GAP in the time it takes to collect on loan payments
versus the time to attract deposits.
e. estimates when embedded options will be exercised.
Answer: a

3. Macaulay's duration:
a. is a weighted average of the time until cash flows are received.
b. is always greater than maturity.
c. is never equal to maturity.
d. directly indicates how much the price of a security will change given a change in interest
rates.
e. estimates when embedded options will be used.
Answer: a

4. Modified duration:
a. estimates when embedded options will be used.
b. directly indicates how much the price of a security will change given a change in interest
rates.
c. is always greater than maturity.
d. All of the above
e. a. and b.
Answer: b
5. Effective duration:
a. estimates when embedded options will be used.
b. directly indicates how much the price of a security will change given a change in interest
rates.
c. is always greater than maturity.
d. is a weighted average of the time until cash flows are received.
e. All of the above
Answer: a

6. A bond has a Macaulay's duration of 10.7 years. If rates fall from 7% to 6%, the bonds price
will:
a. increase by approximately 1%.
b. decrease by approximately 1%.
c. increase by approximately 10%.
d. decrease by approximately 10%.
e. Not enough information is given to answer the question.
Answer: c
Modified Duration = Macaulay's duration/(1+i) = 10.7/1.07 = 10
% Change in Price = -Modified duration * Change in interest rates = -10 * -1% = 10%

7. A bond has a Macaulay's duration of 21 years. If rates rise from 5% to 5.5%, the bonds price
will:
a. increase by approximately 1%.
b. decrease by approximately 1%.
c. increase by approximately 10%.
d. decrease by approximately 10%.
e. Not enough information is given to answer the question.
Answer: d
Modified Duration = Macaulay's duration/(1+i) = 21/1.05 = 20
% Change in Price = -Modified duration * Change in interest rates = -20 * 0.5% = -10%

8. A bond has a Macaulay's duration of 26.56 years. If rates rise from 6.25% to 6.50%, the
bonds price will:
a. increase by approximately 6.25%.
b. decrease by approximately 6.25%.
c. increase by approximately 6.50%.
d. decrease by approximately 6.50%.
e. Not enough information is given to answer the question.
Answer: b
Modified Duration = Macaulay's duration/(1+i) = 26.56/1.0625 = 25
% Change in Price = -Modified duration * Change in interest rates = -25 * 0.25% = -6.25%
9. A 20-year zero coupon bond with a face value of $1,000 is currently selling for $214.55.
Using the bond's modified duration, what is the approximate change in the price of the
bond if interest rates rise by 25 basis points?
a. -49.63%
b. -46.39%
c. -4.96%
d. -4.63%
e. Not enough information is given to answer the question.
Answer: d
Step 1
Find current interest rate
PV = -214.55
FV = 1,000
N = 20
I = ? = 8%

Step 2
Since this is a zero coupon bond, Macaulay’s duration = Maturity = 20
Modified Duration = 20/(1+.07) = 18.52
% Change in Price = -Modified duration * Change in interest rates = -18.52 * 0.25% =- 4.63%

10. A 30-year zero coupon bond with a face value of $10,000 is currently selling for $2,313.77.
Using the bond's modified duration, what is the approximate change in the price of the
bond if interest rates rise by 15 basis points?
a. -15.00%
b. -4.29%
c. -0.43%
d. -0.15%
e. Not enough information is given to answer the question.
Answer: b
Step 1
Find current interest rate
PV = -2,313.77
FV = 10,000
N = 30
I = ? = 5%

Step 2
Since this is a zero coupon bond, Macaulay’s duration = Maturity = 30
Modified Duration = 30/(1+.05) = 28.57
% Change in Price = -Modified duration * Change in interest rates = -28.57 * 0.15% =- 4.29%
11. A 10-year annual coupon bond is currently selling for its par value of $1,000 with an annual
yield of 5%. If the bond is callable at par, what is the effective duration of the bond,
assuming rates change by 1%?
a. 10 years
b. 7.36 years
c. 5.52 years
d. 4.60 years
e. 3.68 years
Answer: e
Step 1
Effective Duration = (Pi- - Pi+)/[P0*(i+ - i-)
If rates fall to 4%, the company will call the bond and P i- will be the call price of $1,000
Find Pi+
FV = 1,000
PMT = 50
I = 5% + 1% = 6%
N = 10
PV = 926.40
Step 2
Effective Duration = (Pi- - Pi+)/[P0*(i+ - i-)
Effective Duration = (1,000 – 926.40)/(1,000*(6% - 4%)) = 3.68 years

12. A 20-year annual coupon bond is currently selling for its par value of $10,000 with an annual
yield of 7%. If the bond is callable at par, what is the effective duration of the bond,
assuming rates change by 2%?
a. 25.00 years
b. 20.00 years
c. 5.52 years
d. 4.56 years
e. 3.68 years
Answer: d
Step 1
Effective Duration = (Pi- - Pi+)/[P0*(i+ - i-)
If rates fall to 5%, the company will call the bond and P i- will be the call price of $10,000
Find Pi+
FV = 10,000
PMT = 700
I = 7% + 2% = 9%
N = 20
PV = 8,174.29
Step 2
Effective Duration = (Pi- - Pi+)/[P0*(i+ - i-)
Effective Duration = (10,000 – 8,174.29)/(10,000*(9% - 5%)) = 4.56 years
13. Which of the following is likely to have a negative effective duration?
 a. A high coupon, interest only mortgage-backed security that is pre-paying at a high rate.
b. A low coupon U.S. Treasury bond.
c. Fed Funds purchased.
d. Demand deposits
e. None of the above can have a negative effective duration.
Answer: a

14. What does a bank's duration gap measure?

a. The duration of short-term buckets minus the duration of long-term buckets.
b. The duration of the bank's assets minus the duration of its liabilities.
c. The duration of all rate-sensitive assets minus the duration of rate-sensitive liabilities.
d. The duration of the bank's liabilities minus the duration of its assets.
e. The duration of all rate-sensitive liabilities minus the duration of rate-sensitive assets.
Answer: b

15. Which of the following allows a security's cash flows to change when interest rates change?
a. Modified duration
b. Macaulay's duration
c. Effective duration
d. Balance sheet duration
e. Income statement duration
Answer: c

16. Which of the following is true regarding duration gap analysis?

a. The magnitude of the duration gap is related to the amount of interest rate risk a bank
is subject to.
b. Management can adjust the duration gap to speculate on future interest rate changes.
c. A positive duration gap means a bank's market value of equity will decrease with an
increase in interest rates.
d. All of the above are true.
e. a. and c.
Answer: d

17. Which of the following would generally be considered price sensitive?

a. Fed funds purchased
b. Fed funds sold
c. Repurchase agreements
d. Demand deposits
e. A 20-year zero coupon bond
Answer: e
18. Put the following steps in duration gap analysis in the proper order.
I. Estimate the economic value of assets, liabilities and equity.
II. Forecast the change in the economic value of equity for various interest rates.
III. Forecast future interest rates.
IV. Estimate the duration of assets and liabilities.
a. III, I, IV, II
b. I, II, III, IV
c. III, IV, I, II
d. IV, I, II, III
e. II, IV, I, III
Answer: a

19. Which of the following is false regarding duration gap analysis?

a. Duration gap analysis does not classify assets as rate-sensitive.
b. Duration gap analysis indicates the potential change in a bank's net interest income.
c. Duration gap accounts for bank leverage.
d. Duration gap accounts for the present value of cash flows associated with all liabilities.
e. Duration gap analysis indicates the potential change in a bank's market value of equity.
Answer: b

Use the following bank information for questions 20 – 24.

Liabilities
Market Duration and Market Duration
Assets Value Rate (Years) Equity Value Rate (Years)
Time
Cash $ 150 Deposits $ 500 4% 1.25
Loans $ 675 10% 2.50 CDs $ 400 6% 3.00
T-Bonds $ 175 5% 5.00 Equity $ 100
Total $ 1,000 $ 1,000

20. What is the weighted average duration of assets?

a. 2.56 years
b. 3.75 years
c. 4.85 years
d. 5.00 years
e. 7.5 years
Answer: a
(675/1,000)*2.5 years +(175/1,000)*5 years = 2.56 years
21. What is the bank’s duration gap?
a. 0.53
b. 0.73
c. 0.91
d. 2.03
e. 4.58
Answer: b
Step 1
Weighted Average Duration of Liabilities = (500/900)*1.25 years + (400/900)*3 years = 2.03
years

Step 2
Duration Gap = Weighted Avg Duration of Assets – (Liabilities/Total Assets)Weighted Avg
Duration of Liabilities
Duration Gap = 2.56 years – (900/1000)*2.03 years = 0.73

22. What is the bank’s weighted average cost of liabilities?

a. $44
b. $76
c. $80
d. $94
e. $102
Answer: a
(500* 4%) + (400*6%) = 44

23. What is the bank’s expected economic net interest income?

a. $14.75
b. $32.25
c. $44.00
d. $76.25
e. $120.25
Answer: b
(10%*$675) + (5%*$175) – (4%*$500) – (6%*$400) = $32.25
24. If interest rates rise 1% for all assets and liabilities, what is the approximate expected
change in the economic value of equity?
a. –$2.56
b. $5.84
c. –$5.84
d. $6.85
e. -$6.85
Answer: e
Step 1
Calculate Weighted Average Return of Assets
(10%*$675/$1,000) + (5%*$175/$1,000) = 7.625% = y

Step 2
EVE = -DGAP[y/(1+y)]MVA = -0.73*[.01/1.07625]*$1,000 = -6.85

Use the following bank information for questions 25 – 29.

Liabilities
Market Duration and Market Duration
Assets Value Rate (Years) Equity Value Rate (Years)
Time
Cash $ 200 Deposits $ 600 2.0% 1.500
Loans $ 800 8.0% 3.750 CDs $ 500 4.5% 3.125
T-Bonds $ 250 4.0% 7.250 Equity $ 150
Total $ 1,250 $ 1,250

25. What is the weighted average duration of assets?

a. 2.56 years
b. 3.85 years
c. 4.85 years
d. 5.00 years
e. 7.5 years
Answer: b
(800/1,250)*3.75 years + (250/1,250)*7.25 years = 3.85 years
26. What is the bank’s duration gap?
a. 0.53
b. 0.73
c. 0.91
d. 1.88
e. 4.58
Answer: d
Step 1
Weighted Average Duration of Liabilities = (600/1,100)*1.5 years + (500/1,100)*3.125 years =
2.24 years

Step 2
Duration Gap = Weighted Avg Duration of Assets – (Liabilities/Total Assets)Weighted Avg
Duration of Liabilities
Duration Gap = 3.85 years – (1,100/1,250)*2.24 years = 1.88 years

27. What is the bank’s weighted average cost of liabilities?

a. $24.9
b. $34.5
c. $80.0
d. $94.3
e. $102.1
Answer: b
(600* 2%) + (500*4.5%) = 34.5

28. What is the bank’s expected economic net interest income?

a. $34.5
b. $32.3
c. $39.5
d. $44.0
e. $120.5
Answer: c
(8%*$800) + (4%*$250) – (2%*$600) – (4.5%*$500) = $39.5
29. If interest rates rise 1% for all assets and liabilities, what is the approximate expected
change in the economic value of equity?
a. –$2.56
b. $5.84
c. –$5.84
d. $22.19
e. -$22.19
Answer: d
Step 1
Calculate Weighted Average Return of Assets
(8%*$800/$1,250) + (4%*$250/$1,250) = 5.92%
Step 2
EVE = -DGAP[y/(1+y)]MVA = -1.88*[-.01/1.0592]*$1,250 = 22.19

30. For a bank that has a negative duration gap, a decrease in interest rates will cause a(n)
_______ in the economic value of assets, a(n) _______ in the economic value of liabilities,
and a(n) _______ in the economic value of equity.
a. increase, decrease, increase
b. increase, increase, decrease
c. increase, increase, increase
d. decrease, decrease, increase
e. decrease, increase, decrease
Answer: a

Essay

1. Discuss the differences between assets and liabilities that are price sensitive and those
that are rate sensitive.

2. Discuss why a bank may have to sacrifice yield to vary its duration gap.

3. What are the strengths and weaknesses of duration gap analysis?

4. Why is it difficult to estimate the duration of demand deposits?

5. How does effective duration differ from modified duration?