Two banks are being examined by regulators to determine the interest rate sensitivity of their balance sheets. Bank A has assets composed solely of a 10 year $1 million loan with a coupon rate and yield of 12 percent. The loan is financed with a 10 year, $1 million CD with a coupon rate and yield of 10 percent. Bank B has assets composed solely of a 7-year, 12 percent zerocoupon bond with a current (market) value of $894,006.20 and a maturity (principal) value of $1,976,362.88. The bond is financed with a 10-year, 8.275 percent coupon, $1,000,000 face value CD with a yield to maturity of 10 percent. The loan and the CDs pay interest annually, with principal due at maturity.
a. If market interest rates increases 1 percent (100 basis points), how do the market values of the assets and liabilities of each bank change? That is, what will be the net effect on the market value of the equity for each bank?
b. What accounts for the differences in the changes in market value of equity between the two banks?
c. Verify your results above by calculating the duration for the assets and liabilities of each bank, and estimate the changes in value for the expected change in interest rates. Summarize your results.