BANK FINANCIAL MANAGEMENT
Instructions: In answering each of the questions below you should explain how you arrived at any calculated answers or show workings. Assignments must be submitted electronically via Turnitin. Please note that Turnitin will convert your file into a pdf format file, therefore your answer should be in “Word” format. Excel spreadsheets may not be converted properly by Turnitin, therefore whilst you may wish to use Excel to answer the questions, it is recommended that if you chose this approach the results of these calculations, particularly those included in the Appendix to your report, should be inserted into a “Word” document as tables.
Your answer should include a cover page (do not use the cover page template) indicating your name, student number and tutorial class and time and your tutor’s name. Your report, including the Executive Summary but excluding the cover page and the Attachment, should be no longer than 2000 words, but may be shorter. You should provide full references to sources used in your report.
The Question
The Balance Sheet for Commercial Banking Company of Australia Limited (CBC) as at 28 February 2018 is shown below as Table 1. CBC is an Authorised Depository Institution in Australia and operates both retail and investment banking operations in Australia. CBC’s assets and liabilities are exclusively domiciled in Australia and hence it does not have any foreign exchange risk.
You are CBC’s Head of Interest Rate Management. You have identified the current market interest rates applicable to the bank’s assets and liabilities and calculated the zero coupon equivalent yields using bootstrapping, and they are set out in (Table 2).
You are required to write a report addressing the questions set out below and provide your recommended strategies to manage the Bank’s interest rate risks as at 28 February 2018.
The intended audience for your report is the senior management team of your bank. Your report should include an Executive Summary (of no more than one page) which means that your main points and findings are given at the start. Sub-headings in the report are a good idea to maintain structure. Your style should be professional and succinct and contain supporting reasons for your conclusions. It is essential that your answer contain supporting tables, graphs and/or diagrams and that these should be embedded/wrapped in the text. The calculations performed under Question 1 should be shown as an Appendix to your report.
Question 1 (50 marks in total)
You have been asked to prepare a Report to Management on the current risk profile of the bank.
(a) Draw the cashflow ladder for CBC’s interest rate sensitive assets and liabilities. You should use the following time buckets; Time 0 for Call or overnight exposures and then six-monthly buckets up to 4 years (e.g. 6 months, 12 months, 18 months etc.). (10 marks)
(b) Using the Zero-Coupon equivalent interest rates calculated from market interest rates shown, in Table 2; calculate the PVBP for each of the “time bucket” cashflows in the Cashflow Ladder and the total PVBP, for all interest rate sensitive assets and liabilities? (10 marks)
(c) You are required to undertake an assessment of past daily changes in interest rates for each of the “timebuckets” set out in Cashflow Ladder assuming that the assessed interest rate changes for each “timebucket” are independent i.e. uncorrelated. You have decided to base this assessment on the past six months daily changes in interest rates, i.e. from 1 September 2017 to 28 February 2018 and you are required to source the appropriate data. Note; depending on the data you have sourced, you may need to interpolate data to estimate interest rate changes for each “timebucket”. A spreadsheet has been provided to assist with this process.
(i) The Bank’s policy is to assess its risk using a 95% confidence level based on an assumption of that future interest rate changes are normally distributed. What is the bank’s DEAR?
(ii) The Bank’s policy also requires its risk to be assessed over a 10 day time horizon. What is the Bank’s Value at Risk (VaR)?
(iii) You should explain the approach that you used, the assumptions that were made to obtain and derive the data and the results and any limitations that you consider exist with the approach or the methodology used. You should also include the workings for this calculation as an Appendix to your paper. (20 marks)
(d) You have been asked to explain to management what these results reveal about the CBC’s interest rate exposure? Management also wishes to know what limitations might exist with the use of these results and what if any assumptions were used to derive the results. The explanation should also include a justification for these assumptions. (10 marks)
Question 2 (50 marks total)
The Bank’s Head of Markets considers that the current monetary policy environment is such that “call” or overnight interest rates are unlikely to change from the current levels in the near term, but in the longer-term interest rates are likely to rise. This has led the Head of Markets to form the view that the yield curve is likely to steepen in the future.
You have been asked to develop a strategy to manage the risks of changes in the value of the portfolio as a result of the potential future interest rate changes identified by the Head of Markets. You are also required to include the following in your Report for Management:
(a) The specific action, if any, that you would recommend be taken, which may include the use of transactions involving the derivative instruments and/or action to restructure the balance sheet, (20 marks)
(b) Show the impact of them on the Bank’s risk profile that you have assessed in Question 1, and (20 marks); and
(c) Give the reasons why you chose the recommended strategy and, if applicable, any assumptions that you have made (and why you made them) on which to base your recommendations; (10 marks)
DATA
Table 1
Commercial Banking Company of Australia Limited
Balance Sheet as at 28 February 2018
Current
$
Current
$
Rate %pa
Rate %pa
Shareholders Funds
Short Term Investments
Capital
11,250,000
6 month Interbank Loans
2.00
10,000,000
Liabilities
Loans
– Call Deposits
1.50
62,000,000
– Overdrafts (daily rate reset)
3.50
9,500,000
– 6 months (180 days)
1.90
34,700,000
– 10 year Housing (6mth rate reset)
4.00
20,500,000
– 2 years (semi-annual)
1.95
4,700,000
– 2 years (semi-annual)
4.05
30,125,000
– 4 years (semi-annual)
2.15
3,175,000
– 4 years (semi-annual)
4.25
45,700,000
104,575,000
115,825,000
115,825,000
Table 2
%pa
Call
6 months
1 year
1.5 years
2 years
2.5 years
3 years
3.5 years
4 years
Par
1.50
1.96
1.97
1.97
1.97
2.04
2.11
2.17
2.24
Zero
1.50
1.96
1.97
1.97
1.98
2.05
2.12
2.18
2.26
Additional Information
1. You have noted that the zero-coupon equivalent interest rates are similar to the PAR rates because the yield curve is relatively flat over the period to 4 years. All of the above interest rates, except Call, are semi-annually compounding interest rates
2. The interest rates shown in the balance sheet are the average interest rates applicable to each of the instrument types and each maturity band in the balance sheet as at the date of the balance sheet. You have assumed for the purposes of the calculations that these rates represent the cost or revenue (as the case may be) for the purposes of calculating cashflows and returns.
3. CBC Bank’s marginal borrowing and lending rates for terms of 6 moths are priced or set by reference to the Australian Bank Accepted Bill (BAB) interest rate and at the Commonwealth Government Security (CGS) rate for terns of one year and longer. These are the interest rates reflected in the interest rates applying to the assets and liabilities in Table 2 above.