finance assignment

Bella2017

SimulationHandbook.pdf

Home >Business & Finance homework help >Financial markets homework help >finance assignment

FINA/ECON 340

Bank Portfolio Simulation Guide and Worksheets

Version 1.3

This document is intended as a guide for the completion of the five rounds of the simulation. Here explanations

of calculations and samples of inputs are provided in red font with the description of the assignments from the

course modules in black. Use this as a guide to completing the tables in the templates your instructor provides to

you.

Assignment 2-2 (6-Week Class) or 3-2 (12-Week Class): Initial Bank Portfolio

Overview

In this course you will be asked to make decisions involving the management of a bank in a multi-phase market

simulation. The market simulation will consist of five rounds. At the beginning of each round, you will be given

the probability of possible states of the world that will subsequently occur during that round. You will then

make your allocation decisions based on the returns possible in these probable states. At the end of each phase,

you revalue your balance sheet, calculate your institution’s profitability for the period, and make new

allocations for the next round. Please note that the recalculated financial position of your institution at the end

of each round will become the starting financial position for the next round. The goal of the simulations is to

maximize the return to your shareholders in each phase. Your grade in each phase will be determined by your

performance in the simulation, the rationale you provide for the allocation decisions you make, and short

answer responses to questions related to the coursework.

In Round 1 you are asked to allocate initial equity capital among alternative liquid investments: cash, one-year

Treasury bills, 5-year Treasury notes, and 15-year Treasury bonds. Your goal is to maximize return and

minimize risk in this start-up phase until you are able to generate riskier assets, such as loans, and leverage your

initial equity with debt.

In Round 2 of the simulation you begin to diversify the composition of your assets, choosing among types of

loans with varying levels of risk and return. You can also grow your assets further by adding debt with

alternative sources of liabilities, including deposits and borrowed funds. Note that different assets and liabilities

have different returns and default rates based on the state of the world that occurs.

In Round 3 new capital requirements are imposed by regulators that may force you to made adjustments in the

risk carried on your balance sheet, including possibly taking some risk off balance sheet.

In Round 4 of the simulation you can expand your operations internationally with new asset and funding

alternatives.

In Round 5, the final round, you conduct a financial analysis of your bank and assess its performance.

Action Items for Round One

1. Assume that you have been granted a charter to open a bank with an initial capitalization of $1,000,000. Before you begin to build a loan portfolio and take deposits and/or borrow funds, you have the following liquid

investment alternatives for your equity funds:

In this scenario you face only interest rate risk. There is no credit/default risk and no liquidity risk on U.S.

Treasury securities. In order to maximize your profitability you will want to maximize the interest income you

earn from your allocation net of any gains or losses in the value of securities due to interest rate changes. In this

round we are assuming no payments to shareholders, who have provided the initial equity, and no liabilities, so

there is no interest expense. As a result, your bank’s profitability in the first round will be its interest income net

of any gain or loss to the value of the Treasury securities held.

In these scenarios we will assume 7 possible outcomes with probabilites that approximate a normal distribution

and variability up to 3 standard deviations

More specifically, the seven outcomes in each round with their associated probabilities will be determined by

your instructor’s throw of two six-sided dice as follows:

In Round 1 the possible scenarios of future interest rates at the end of one year and their associated probabilities

are follows:

Outcomes Outcome

Probability

Cash One-Year U.S.

Treasury Bills

Five-Year U.S.

Treasury Notes

15-Year U.S.

Treasury Bonds

1 16.67% No Change No Change No Change No Change

2 25% No Change 0.36% 0.88% 1.86%

3 25% No Change 0.06% 0.58% 1.56%

4 13.89% No Change No Change 0.78% 1.86%

5 13.89% No Change No Change 0.58% 1.46%

Current Annual

Rates of Return, t=0

Cash 0%

One-Year U.S. Treasury Bills 0.16%

5-Year U.S. Treasury Notes 0.68%

15-Year U.S. Treasury Bonds 1.66%

Outcomes Outcome

Probability

Two Dice

Roll

Numerical

Total

1 16.67% 7

2 25% 3, 4, or 5

3 25% 9, 10, or 11

4 13.89% 6

5 13.89% 8

6 2.78% 2

7 2.78% 12

100.0%

6 2.78% No Change 0.50% 0.58% 0.75%

7 2.78% No Change 0.75% 0.68% 0.50%

Please note that any variability in future interest rates involves changes in the U.S. Treasury yield curve as

follows:

Outcome 1: No Change

Outcome 2: Upward shift by 20 basis points (bp) in all securities

Outcome 3: Downward shift by 10 bp in all securities

Outcome 4: Upward increase in the slope of the Treasury yield curve

Outcome 5: Decrease in the slope of the Treasury yield curve

Outcome 6: Flattening of the Treasury yield curve

Outcome 7: Inversion of the Treasury yield curve

The outcome will be determined by your instructor and advised to you after Round 1 submissions.

Based on the possible outcomes you face, allocate your initial equity of $1,000,000 among the asset

possibilities provided in the initial balance sheet below:

Let’s decide to equally distribute our $1,000,000 equity capital across the four asset alternatives as follows:

Balance Sheet t=0: Start of Round 1

Assets Liabilities and Shareholders’ Equity

Cash $250,000 Liabilities $0

One-Year U.S.

Treasury Bills

$250,000 Common Stock $1,000,000

Five-Year U.S.

Treasury Notes

$250,000 Retained Earnings $0

15-Year U.S.

Treasury Bonds

$250,000 Total Shareholders’

Equity

$1,000,000

Total Assets $1,000,000 Total Liabilities and

Shareholders’ Equity

$1,000,000

Of course, make sure Total Assets = Total Liabilities and Shareholders’ Equity = $1,000,000

2. Respond to the Action Items as required. Your instructor will provide you with the required worksheet for this assignment. Pay attention to the action items and the associated text reference or hint that is provided.

Assignment 3-4 (6-Week Class) or 5-4 (12-Week Class): Bank Portfolio-Round 2

Action Items for Round Two

Part A:

1. Revisit the liquid asset allocation you made in Round One in light of the outcome (1 through 7) provided by

your instructor:

Outcomes Outcome

Probability

Cash One-Year U.S.

Treasury Bills

Five-Year U.S.

Treasury Notes

15-Year U.S.

Treasury Bonds

1 16.67% No Change No Change No Change No Change

2 25% No Change 0.36% 0.88% 1.86%

3 25% No Change 0.06% 0.58% 1.56%

4 13.89% No Change No Change 0.78% 1.86%

5 13.89% No Change No Change 0.58% 1.46%

6 2.78% No Change 0.50% 0.58% 0.75%

7 2.78% No Change 0.75% 0.68% 0.50%

Outcome 1: No Change

Outcome 2: Upward shift by 20 basis points (bp) in all securities

Outcome 3: Downward shift by 10 bp in all securities

Outcome 4: Upward increase in the slope of the Treasury yield curve

Outcome 5: Decrease in the slope of the Treasury yield curve

Outcome 6: Flattening of the Treasury yield curve

Outcome 7: Inversion of the Treasury yield curve

Let’s say the instructor advises that the Round 1 probabilistic outcome is 3:

Outcomes Outcome

Probability

Cash One-Year U.S.

Treasury Bills

Five-Year U.S.

Treasury Notes

15-Year U.S.

Treasury

Bonds

3 25% No Change 0.06% 0.58% 1.56%

Outcome 3: Downward shift by 10 bp in all securities

Based on the actual outcome at the end of t=1 and assuming all notes and bonds initially traded at par, that is,

the t=0 annual rate is the coupon rate, complete the following table:

The calculations are explained below the table.

Round One

Allocation in $

(a)

Annual

Rates of

Return

t=0

(b)

Outcome 3

Rates

t=1

(c)

Interest Income

t=1

(d)

Asset Valuation

t=1

(e)

Cash

$250,000 0% 0% 0 $250,000

One-Year

U.S. T-

Bills

$250,000 0.16%

N/A (See

below)

N/A (See below)

$250,400 =

$250,000 +

($250,000 x

0.0016) =

$250,000 + $400

Five-Year

U.S. T-

Notes

$250,000 0.68%

0.58%

=0.0068 x

$250,000 =

$1,700

$250,985.6665

15-Year

U.S. T-

Bonds

$250,000 1.66%

1.56%

=0.0166 x

$250,000 =

$4,150.

$253,122.4324

Total $1,000,000

$5,850

$250,000 in cash

and $754,508.10 in

securities =

$1,004,508.10

Let’s look at the interest income and change in valuation for each of four assets.

Cash: The value of the investment in cash is unchanged with no interest income.

T-Bills: For T-bills even though market rates have changed with Outcome 3 we bought them at a discount at the

initial prevailing rate of 0.16% and have held them to maturity. The income we earn (the difference between the

initial discounted purchase price and the face value at maturity) is treated as a gain and not as interest earned.

The gain is the annual 0.16% earned on the initial investment in the T-bills over the course of the year, or

0.0016 x $250,000 = $400. At the end of the round at maturity the face value of the T-bills equals $250,400

(including the initial principal invested and gain).

T-Notes:

Assuming coupon payments occur once each year, the interest income we earn during the year is the coupon

payment we receive. Since it is assumed that we bought the T-notes at par, the initial market rate is the coupon

rate:

T-Note Interest Income = Coupon rate · Principal

= Coupon rate of 0.0068 x Par Value of the initial investment of $250,000

= 0.0068 x $250,000 = $1,700

Next we want to calculate the current value of the now 4-year T-notes. From our principles class we know that a

decrease in market rates should increase the note’s value:

The year-end (t=1) value for the initial five-year T-notes is calculated as follows:

Four-Year T-Note Value t=1= Coupon payment · Present Value Interest Factor Annuity + Face/Principal Value ·

Present Value Interest Factor for Single Sum

( ) (

( ) )

)

( )

= ( ) (

( ) )

)

( )

= $1700(3.94267) + $244,283.1343

=$6,702.53226 +$244,283.1343

= $250,985.6665

We can then enter these values in the chart for interest income on the T-notes and their value at the end of the

year.

T-Bonds:

We now perform similar calculations for the now 14-year T-bonds.

Again, assuming coupon payments occur once each year, the interest income we earn during the year is the

coupon payment we receive. Since it is assumed that we bought the T-bonds at par, the initial market rate is the

coupon rate:

For the T-bond the year’s annual interest income:

= Coupon rate of 0.0166 x Par Value of the initial investment of $250,000

= 0.0166 x $250,000 = $4,150.

Next we want to calculate the current value of the now 14-year bonds. From our principles class we know that a

decrease in market rates should increase the bond’s value:

Fourteen-Year T-Bond Value t=1 ( ) (

( ) )

)

( )

= ( ) (

( ) )

)

( )

= $4,150(12.48973) + $201,290.0547

= $51,832.37771 + $201,290.0547

= $253,122.4324

Based on the totals above create a balance sheet at t=1. Assume no dividends, that is, all interest income is

retained and that all retained earnings are held as cash.

--Cash at t= 1 equals Cash at t=0 plus total interest income for the period.

$250,000 + $5,850 (that is, $1,700 plus $4,150) = $255,850

--Securities at t=1 equal total Asset Valuation of Treasury securities (bills, notes and bonds) at t=1. $250,400 +

$250,985.6665 + $253,122.4324 =$754,508.10.

--Common Stock equals Common Stock at t=1

--Retained Earnings equal interest income in period 1 net of any gains or losses in Treasury securities. Or the

difference between total assets at t=1 and total assets at t=0 = $1,010,358.10 - $1,000,000 = $10,358.10.

Balance Sheet t=1: End of Round 1

Assets Liabilities and Shareholders’ Equity

Cash $255,850.00 Total Liabilities $0

Securities $754,508.10 Common Stock $1,000,000

Retained Earnings $10,358.10

Total Shareholders’

Equity

$1,010,358.10

Total Assets $1,010,358.10 Total Liabilities and

Shareholders’ Equity

$1,010,358.10

Of course, make sure Total Assets = Total Liabilities and Shareholders’ Equity

This then is the balance sheet that begins Round 2 before you leverage your bank.

2. Respond to the Action Items as required. Your instructor will provide you with the required worksheet for this assignment. Pay attention to the action items and associated resource or hint that is provided.

Part B:

1. In Round 2 you are asked to grow your bank’s balance sheet through the expansion of assets funded by liabilities. Specifically, you can now leverage (increase the liabilities of) your bank up to a multiple of

12x total shareholders’ equity. Using Balance Sheet t=1: Start of Round 2 make decisions regarding

your Round 2 asset allocations and sources of funds. Here are your new alternatives for Round 2:

Assets

--Consumer Loans will earn on average 10% per annum and require a 4% loan loss reserve

--Residential Mortgages will earn on average 5% per annum and require a 2% loan loss reserve

--Commercial and Industrial (C&I) Loans will earn on average 4% per annum and require a 1% loan

loss reserve

2. Liabilities --Deposits, net of the expenses to attract them, are forecasted to cost 2% per annum

--Borrowed Funds, mainly through the interbank market, are forecasted to cost 1% per annum

Consolidate all Treasury securities in Round One into a single balance sheet item for Rounds 2-5. All

securities going forward will be one-year Treasury bills. In other words, assume going forward that all

gains on T-bills in any one round are added to the total securities for the next round. For example, if

your bank had $200,000 in T-bills and $400,000 in ten year bonds, the Securities line item on all

subsequent rounds would be $600,000. All subsequent income calculations would be treated as

accretion.

To complete Balance Sheet t=2: Start of Round 2 take the following steps:

-- First, copy your completed Balance Sheet t=1: End of Round 1 into the balance sheet below. Again,

going forward we will assume all investments in “Securities” are held to maturity as one-year Treasury

bills and any gains are reinvested into securities.

-–Next, decide on the amount of your bank’s leverage, that is, how much, either through deposits or

borrowed funds, you choose to raise up to 12x the existing shareholders’ equity at the end of Round One.

–Then allocate all your liabilities and shareholders’ equity among the asset alternatives taking into account

the following probability of return and cost outcomes in Round 2:

In Round 2 the possible scenarios of future interest rates at the end of one year and their associated

probabilities are as follows: :

Outcomes 1 2 3 4 5 6 7

Outcome

Probability

16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities

(T-bills)

0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Residential

Mortgages

Net 2% Net 3% Net 1% Net 4% Net 0.5% Net 4% Net 0%

C&I Loans Net 3% Net 4% Net 2% Net 5% Net 1% Net 5% Net 0.5%

Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of

borrowed funds

Notice first that the balance sheet items at the end of Round 1 are in bold font below. Next we will choose to

leverage our bank to the full 12x equity level possible, so we will then seek to borrow 12 x Total Shareholders’

Equity of $1,010,358.10 = 12 x $1,010,358.10 = $12,124,297.20. We will round this down to $12,000,000 and

divide it equally ($6,000,000) between Deposits and Borrowed Funds. We can now sum these new liabilities

with the inherited Total Shareholders’ Equity to arrive at Total Liabilities and Shareholders’ Equity of

$13,010,358.10.

Next, we will allocate the new borrowing among the possible asset items. We choose to leave Cash and

Securities unchanged and distribute the new borrowed funds equally among the three new classifications of

loans ($12,000,000/3 = $4,000,000.00). We then sum all the assets to get Total Assets for Round 2.

Balance Sheet t=2: Start of Round 2

Assets Liabilities and Shareholders’ Equity

Cash $255,850.00 Deposits $6,000,000

Securities (T-

Bills) $754,508.10 Borrowed Funds $6,000,000

Consumer

Loans*

$4,000,000.00 Total Liabilities $12,000,000

Residential

Mortgages*

$4,000,000.00 Common Stock $1,000,000

C&I Loans* $4,000,000.00 Retained Earnings $10,358.10

Total Shareholders’

Equity $1,010,358.10

Total Assets $13,010,358.10 Total Liabilities and

Shareholders’ Equity

$13,010,358.10

*Loans figures are net of loan loss provisions.

Again, make sure Total Assets = Total Liabilities and Shareholders’ Equity

We are advised that the Outcome for Round 2 is Number 2.

Outcome 2

Outcome

Probability

25%

Cash 0%

Securities

(T-bills)

0.25%

Consumer

Loans

Net 7%

Residential

Mortgages

Net 3%

C&I Loans Net 4%

Deposits 2%

Borrowed

Funds

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

From Balance Sheet t=2: Start of Round 2 we fill in the allocations and Outcome 2 rates and calculate interest

income and expense.

1. Based on the actual outcome at the end of t=2, complete the following table to determine your bank’s

income in Round 2:

Round Two

Allocation in $

(a)

Outcome

Rates

t=2

(b)

Interest Income

t=2

(c)

Interest Expense

t=2

(d)

Cash $255,850 0% 0 0

Securities (T-Bills) $754,508.10 0.25% N/A: Gain

(See below.)

Net Consumer Loans $4,000,000 Net 7% $280,000 0

Net Residential

Mortgages

$4,000,000 Net 3% $120,000 0

Net C&I Loans $4,000,000 Net 4% $160,000 0

Deposits $6,000,000 2% 0 $120,000.00

Borrowed Funds $6,000,000 1% 0 $60,000.00

Total =

$560,000.00

Total =

$180,000.00

Subtract Total Interest Expense from Total Interest Income and add the result to your bank’s Retained

Earnings on its Balance Sheet. $560,000 - $180,000 = $380,000.

Calculate the gain on T-bills and also add that to retained earnings.

$754,508.10 · 0.0025 = $1,886.27

Addition to retained earnings: Net interest income + Securities gain = $380,000 + $1,886.27 =

$381,886.27

Total retained earnings: = Retained earnings at the beginning of year + addition to retained earnings

= $10,358.10 + $381,886.27 = $392,244.37

Add Net Interest Income to Cash: $255,850 + $380,000 = $635,850

Add Gain to Securities (T-Bills): $754,508.10 + $1,886.27 = $756,394.37

*Loans figures are net of loan loss provisions.

2. Respond to the Action Items as required. Your instructor will provide you with the required worksheet for this assignment.

ROA = (Net interest income + Securities gain)/Total assets =Addition to retained earnings/Total assets

= $381,886.27/$13,392,244.37 = 0.02852 x 100 = 2.85%

ROE = (Net interest income + Securities gain)/Total shareholders’ equity = Addition to retained earnings/Total

shareholders’ equity = $381,886.27/$1,392,244.37

= 0.2743 x 100 = 27.4%

Assignment 4-2 (6-Week Class) or 7-2 (12-Week Class): Bank Portfolio-Round 3

Action Items for Round Three

Part A:

1. Revise your asset allocation and funding source decisions for Round Three in light of the new capital requirements and the following possible outcomes (1 through 7). :

Outcomes 1 2 3 4 5 6 7

Outcome

Probability 16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities

(T-bills) 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans:

Interest Earned Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Balance Sheet t=2: End of Round 2

Assets Liabilities and Shareholders’ Equity

Cash $635,850.00 Deposits $6,000,000

Securities (T-Bills) $756,394.37 Borrowed Funds $6,000,000

Consumer Loans* $4,000,000 Total Liabilities $12,000,000

Residential

Mortgages*

$4,000,000 Common Stock $1,000,000

C&I Loans* $4,000,000 Retained Earnings $392,244.37

Total Shareholders’ Equity $1,392,244.37

Total Assets $13,392,244.37 Total Liabilities and

Shareholders’ Equity

$13,392,244.37

Consumer Loans:

% Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Residential

Mortgages: Sale

Interest Earned

Net 2% Net 3% Net 1% Net 4% Net 0.5% Net 4% Net 0%

Residential

Mortgages: %

Sale Price

100% 100.25% 99.75% 100.50% 99.50% 102% 98%

C&I Loans:

Interest Earned Net 3% Net 4% Net 2% Net 5% Net 1% Net 5%

Net

0.5%

C&I Loans: %

Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

Part B:

1. In Round 3 you are asked to adjust your bank’s balance sheet to reflect regulatory changes that require that you hold a minimum level of capital. Assume that bank regulators are now requiring banks to carry total

shareholders’ equity equal to 4% of risk-weighted assets, which in this simulation are the three categories of

loans. (Cash and T-Bills are assumed to be risk-free and thus have a risk weighting of 0 %.) To calculate

your current level of capital for your End of Round 2/Start of Round 3 Balance Sheet divide Total

Shareholders’ Equity by the sum of the three categories of loans:

Balance Sheet t=2: End of Round 2

Total Shareholders’ Equity (a) $1,392,244.37

Consumer Loans (b) $4,000,000

Residential Mortgages (c) $4,000,000

C&I Loans (d) $4,000,000

Tier I Capital (a/(b+c+d) $1,392,244.37/$12,000,000 = 11.602%

Based on our current equity level of $1,392,244.37, we would not reach the Tier I Capital limit of 4% on

risk-weighted assets until

0.04 = $16,706,932.44/X X · 0.04 = $1,392,244.37

X = $1,392,244.37/0.04 X = risk-weighted assets = $34,806,109.25

If your total Tier I Capital ratio is below 4%, you will have to 1) reduce the assets on your balance sheet by

selling loans and/or 2) issuing more common stock (which will dilute existing shareholders’ returns).

Accordingly, make your Round 3 balance sheet allocations to reflect this new requirement and the

probabilities of the possible outcomes that now include the amount you will receive on the sale of any loans

reflecting both any deterioration in credit quality and fees to you, the loan-originating bank.

Due to the bank’s profitability there is no need to shrink the bank’s balance sheet. In fact, we can expand

our balance sheet by further borrowing up to the 12x equity limit.

12x Current Equity = 12 · $1,392,244.37 = $16,706,932.44

We will expand our total liabilities by $4,500,000 from $12,000,000 to $16,500,000 using borrowed funds.

2. Revise your asset allocation and funding source decisions for Round Three in light of the new capital requirements and the following possible outcomes (1 through 7). :

Outcomes 1 2 3 4 5 6 7

Outcome

Probability 16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities (T-bills) 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans:

Interest Earned Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Consumer Loans: %

Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Residential Mortgages:

Sale Interest Earned Net 2% Net 3% Net 1% Net 4% Net 0.5% Net 4% Net 0%

Residential Mortgages:

% Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

C&I Loans: Interest

Earned Net 3% Net 4% Net 2% Net 5% Net 1% Net 5%

Net

0.5%

C&I Loans: % Sale

Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

We increase Borrowed Funds by $4,500,000. And remain bullish and shrink our cash to $135,850.00:

End-of-Year 2: Cash = $635,850.00 Beginning-of-Year 3: Cash = $135,850.00

Amount of cash to reinvest in interest-earning assets $635,850.00 - $135,850.00 = $500,000.00

With the increase in Borrowed Funds and the redeployment of cash we have the ability to increase assets by

$4,500,000 + $500,000.00 = $5,000,000.00. Let’s increase our Consumer and Residential Mortgage loans each

by $2,500,000. These decisions result in the following Balance Sheet for the beginning of Round 3:

*Loan figures are net of loan loss provisions.

Assignment 5-4 (6-Week Class) or 9-4 (12-Week Class): Bank Portfolio-Round 4

Action Items for Round Four

Part A:

1. Revisit the asset allocation you made in Round Three in light of the outcome (1 through 7) provided by

your instructor:

Outcomes 1 2 3 4 5 6 7

Outcome

Probability 16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities (T-bills) 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans:

Interest Earned Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Consumer Loans: %

Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Residential

Mortgages: Sale

Interest Earned

Net 2% Net 3% Net 1% Net 4% Net .5% Net 4% Net 0%

Balance Sheet t=3: Start of Round 3

Assets Liabilities and Shareholders’ Equity

Cash $135,850.00 Deposits $6,000,000

Securities (T-Bills) $756,394.37 Borrowed Funds $10,5000,000

Consumer Loans* $6.500,000.00 Total Liabilities $16,500,000

Residential

Mortgages*

$6.500,000.00 Common Stock $1,000,000

C&I Loans* $4,000,000.00 Retained Earnings $392,244.37

Total Shareholders’

Equity

$1,392,244.37

Total Assets $17,892,244.37

Total Liabilities and

Shareholders’ Equity

$17,892,244.37

Loans Sold: $0

Residential

Mortgages: % Sale

Price

100% 100.25% 99.75% 100.50% 99.50% 102% 98%

C&I Loans: Interest

Earned Net 3% Net 4% Net 2% Net 5% Net 1% Net 5%

Net

0.5%

C&I Loans: % Sale

Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

We are advised that Outcome 5 has occurred.

Outcomes

Outcome

Probability

13.89%

Cash 0%

Securities

(T-bills)

0.25%

Consumer

Loans: Interest

Earned

Net 4%

Consumer

Loans: % Sale

Price

99.50%

Residential

Mortgages:

Interest Earned

Net

0.5%

Residential

Mortgages: %

Sale Price

99.50%

C&I Loans:

Interest Earned

Net 1%

C&I Loans: %

Sale Price

99.50%

Deposits 2%

Borrowed

Funds

Outcome 5: Strong economic decline: even higher loan losses than estimated

2. Based on the actual outcome at the end of t=3, complete the following table to determine your bank’s

income in Round 3:

Round Three

Allocation in $

(a)

Outcome

Rates

t=3

(b)

Interest Income

t=3

(c)

Interest Expense

t=3

(d)

Cash

$135,850.00 0% 0 0

Securities (T-Bills) $756,394.37 0.25% N/A: Gain

(See below.)

Net Consumer Loans $6.500,000.00 Net 4% $260,000.00 0

Net Residential

Mortgages

$6.500,000.00 Net 0.5% $32,500.00 0

Net C&I Loans $4,000,000.00 Net 1% $40,000.00 0

Deposits $6,000,000 2% $120,000.00

Borrowed Funds $10,500,000 1% $105,000.00

Total =

$332,500.00

Total =

$225,000.00

Face Value at

End of Round 2

(a)

Pct Sale

Price

(b)

Sold Value in

Round 3

(c)

Gain or Loss on

Sold Loans

(d)

Total Loans Sold $0 = c - a

 Calculate the gain on T-bills and also add that to Retained Earnings. $756,394.37 · 0.0025 = $1,890.99

 Subtract Total Interest Expense ($225,000.00) from Total Interest Income ($332,500.00) and add the result ($107,500.00) to your Cash and to your bank’s

Retained Earnings on its Balance Sheet.

 Also, add Gain or Loss on Sold Loans to Retained Earnings. We sold none but if we had sold, say, $1,000,000 of C&I loans, then under Outcome 5 we would

multiply $1,000,000 by the “C&I Loans: % Sale Price” of 99.5% to get $995,000

on the sale and this results in $5,000 loss on the sale in this scenario that we would

subtract from Retained Earnings. .

We add the result ($1,890.99 + $107,500.00 = 109,390.99) to Retained Earnings in creating an End of

Round 3 Balance Sheet.

Balance Sheet t=3: End of Round 3

Assets Liabilities and Shareholders’ Equity

Cash $243,350.00 (= $135,850.00 +

$107,500.00)

Deposits $6,000,000

Securities (T-

Bills)

$758,285.36 (=$756,394.37 +

$1,890.99)

Borrowed Funds $10,5000,000

Consumer

Loans*

$6.500,000.00 Total Liabilities $16,500,000

Residential

Mortgages*

$6.500,000.00 Common Stock $1,000,000

C&I Loans* $4,000,000.00 Retained Earnings $501,635.36

(=$392,244.37 +

$107,500.00 +

$1,890.99

Total Shareholders’

Equity

$1, 501,635.36

Total Assets $18,001,635.36

Total Liabilities and

Shareholders’ Equity

$18,001,635.36

*Loans figures are net of loan loss provisions.

3. Respond to the Action Items as required. Your instructor will provide you with the required worksheet

for this assignment.

Net income = Gain on T-bills + Net interest income =$1,890.99 + $107,500.00

= $109,390.99

ROA = $109,390.99/$18,001,635.36 = 0.608%

ROE = $109,390.99//$1, 501,635.36 = 7.285%

Part B:

1. In Round 4 you will have expanded opportunities to lend overseas and fund your operations in the Eurodollar market and in foreign currencies. Specifically, you will now be able to 1) make and fund

C&I loans denominated in Euros and/or 2) fund your US$ operations in Eurodollars. Assume that the

4% Tier I capital requirement remains and that any C&I loans denominated in euros are, like U.S.

domestic loans, assessed a 100% risk weighting.

Balance Sheet t=4: Start of Round 4

Total Shareholders’ Equity (a) $1, 501,635.36

Domestic U.S. Consumer Loans (b) $6.500,000.00

Domestic U.S. Residential Mortgages (c) $6.500,000.00

Domestic U.S. C&I Loans (d) $4,000,000.00

Euro-Denominated C&I Loans (e) (€ Amount x $1.30 per €) = $

Tier I Capital (a/(b+c+d+e) $1, 501,635.36/(Domestic Loans=$17,000,000.00

and no EUR-denominated loans yet) = 8,833%, so

still far from the 4% minimum

2. Revise your asset allocation and funding source decisions for Round Four in light of these new lending and funding alternatives and the following possible outcomes (1 through 7). Notice that the outcomes

below assume euro interest rates are not perfectly correlated with U.S. dollar interest rates and that

sourcing US$ in the Eurodollar market is generally cheaper than sourcing dollars domestically with the

exception of an occurrence of a liquidity crisis. Also note that all balance sheet items are denominated in

US$ except where specifically noted.

Outcomes

1 2 3 4 5 6 7

Outcome

Probability 16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities

(T-bills) 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans:

Interest Earned Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Consumer Loans:

% Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Residential

Mortgages: Sale

Interest Earned

Net 2% Net 3% Net 1% Net 4% Net 0.5% Net 4% Net 0%

Residential

Mortgages:

% Sale Price

100% 100.25% 99.75% 100.50% 99.50% 102% 98%

C&I Loans:

Interest Earned Net 3% Net 4% Net 2% Net 5% Net 1% Net 5%

Net

0.5%

C&I Loans:

% Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Domestic Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Eurodollar

Borrowing 0.9% 0.9% 0.9% 0.9% 0.9% 0.45% 5%

€-Denominated

C&I Loans:

Interest Earned

Net 4% Net 4% Net 4% Net 4% Net 2% Net 4% Net 0%

€-Denominated

Borrowed Funds 1.5% 1.5% 1.5% 1.5% 1.5% 0.75% 6%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

Since we are well above minimum capital levels, we can again increase our debt to reestablish a 12x

multiple of debt to equity ratio. Current equity equals $1, 501,635.36 and 12x that equals $18,019,624.32.

Let’s round that down to $18,000,000, leaving us with ($18,000,000 – Existing Debt of $17,000,000 =)

$1,000,000 of additional debt capacity. This $1,000,000 plus additional cash from last period’s earnings

($243,350.00 - $135,850.00 = $107,500.00) for a total of $1,107,500.00 can now be deployed in interest-

earning assets.

Since the spread on €-denominated C&I loans seems attractive and should provide some diversification

benefits, we’ll use this additional $1,107,500.00 to make €-denominated C&I loans and match fund them

exclusively in €. At an assumed spot rate of USD1.30 per € this results in €-denominated C&I loans and

liabilities of €851,923.08 (=$1,107,500.00/$1.30)

We also see that Eurodollar funding is cheaper than any of the previous US dollar-based alternatives, so

let’s reduce Borrowed Funds from $10,500,000 to $4,000,000 and fund the balance ($6,500,000) in

Eurodollars.

Balance Sheet t=4: Start of Round 4

Assets Liabilities and Shareholders’ Equity

Cash $243,350.00 Deposits $6,000,000

Securities (T-Bills) $758,285.36 Borrowed Funds $4,000,000

Consumer Loans* $6.500,000.00 Eurodollar Borrowing $6,500,000

Residential

Mortgages*

$6.500,000.00 €-Denominated

Borrowed Funds

€851,923.08

(=$1,107,500.00 for

reporting purposes)

C&I Loans* $4,000,000.00 Total Liabilities $17,607,500.00

€-Denominated

C&I Loans:

€851,923.08

(=$1,107,500.00

for reporting

purposes)

Common Stock $1,000,000

Retained Earnings $501,635.36

Total Shareholders’

Equity

$1,501,635.36

Total Assets $19,109,135.36 Total Liabilities and

Shareholders’ Equity

$19,109,135.36

Loans Sold: $0

*Loans figures are net of loan loss provisions.

Assignment 6-2 (6-Week Class) or 11-2 (12-Week Class): Bank Portfolio-Final Analysis

Action Items for Final Analysis

Part A:

1. Revisit the asset allocation you made in Round Four in light of the outcome (1 through 7) provided by your instructor:

Outcomes

1 2 3 4 5 6 7

Outcome

Probability 16.67% 25% 25% 13.89% 13.89% 2.78% 2.78%

Cash 0% 0% 0% 0% 0% 0% 0%

Securities (T-bills) 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%

Consumer Loans:

Interest Earned Net 6% Net 7% Net 5% Net 8% Net 4% Net 8% Net 2%

Consumer Loans: %

Sale Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Residential

Mortgages: Sale

Interest Earned

Net 2% Net 3% Net 1% Net 4% Net

0.5% Net 4% Net 0%

Residential

Mortgages: % Sale

Price

100% 100.25% 99.75% 100.50% 99.50% 102% 98%

C&I Loans: Interest

Earned Net 3% Net 4% Net 2% Net 5% Net 1% Net 5%

Net

0.5%

C&I Loans: % Sale

Price 100% 100.25% 99.75% 100.50% 99.50% 102% 98%

Domestic Deposits 2% 2% 2% 2% 2% 2% 2%

Borrowed Funds 1% 1% 1% 1% 1% 0.50% 3%

Eurodollar

Borrowing 0.9% 0.9% 0.9% 0.9% 0.9% 0.45% 5%

€-Denominated C&I

Loans: Interest

Earned

Net 4% Net 4% Net 4% Net 4% Net 2% Net 4% Net 0%

€-Denominated

Borrowed Funds 1.5% 1.5% 1.5% 1.5% 1.5% 0.75% 6%

Outcome 1: No Change

Outcome 2: Moderate economic expansion: slightly fewer loan losses than estimated

Outcome 3: Moderate economic decline: slightly higher loan losses than estimated

Outcome 4: Strong economic expansion: even fewer loan losses than estimated

Outcome 5: Strong economic decline: even higher loan losses than estimated

Outcome 6: Asset Bubble: fewer loan losses and a drop in the cost of Borrowed Funds

Outcome 7: Liquidity Crisis: even higher loan losses and an increase in the cost of borrowed funds

We are advised that Outcome 5 has occurred again.

Outcomes

Outcome

Probability

13.89%

Cash 0%

Securities

(T-bills)

0.25%

Consumer

Loans:

Interest

Earned

Net 4%

Consumer

Loans: %

Sale Price

99.50%

Residential

Mortgages:

Sale

Interest

Earned

Net

0.5%

Residential

Mortgages:

% Sale

Price

99.50%

C&I Loans:

Interest

Earned

Net 1%

C&I Loans:

% Sale

Price

99.50%

Domestic

Deposits

Borrowed

Funds

Eurodollar

Borrowing

0.9%

€-

Denominat

ed C&I

Loans:

Interest

Earned

Net 2%

€-

Denominat

Borrowed

Funds

1.5%

Outcome 5: Strong economic decline: even higher loan losses than estimated

2. Based on the actual outcome at the end of t=4, complete the following table to determine your bank’s income in Round 4:

Round Four

Allocation in $

(a)

Outcome

Rates

t=4

(b)

Interest

Income t=4

(c)

Interest Expense

t=4

(d)

Cash $243,350.00 0% 0 0

Securities (T-Bills) $758,285.36 0.25% N/A: Gain

(See below.) 0

Net Consumer Loans $6.500,000.00 Net 4% $260,000.00 0

Net Residential

Mortgages $6.500,000.00 Net 0.5% $32,500.00 0

Net C&I Loans $4,000,000.00 Net 1% $40,000.00 0

Net €-Denominated

C&I Loans

€851,923.08

(=$1,107,500.00

for reporting

purposes)

Net 2% $22,150.00 0

Deposits $6,000,000 2% 0 $120,000.00

Borrowed Funds $4,000,000 1% 0 $40,000.00

Eurodollar Borrowing $6,500,000 0.9% 0 $58,500.00

€-Denominated

Borrowed

€851,923.08

(=$1,107,500.00

for reporting

purposes)

1.5% 0 $16,612.50

Total =

$354,650.00

Total =

$235,112.50

Face Value at End

of Round 3

(a)

Pct Sale

Price

(b)

Sold Value in

Round 4

(c)

Gain or Loss on

Sold Loans

(d)

Total Loans Sold $0 = c - a

 Calculate the gain on T-bills and add that to retained earnings. $758,285.36 · 0.0025 = $1,895.71

 Subtract Total Interest Expense from Total Interest Income and add the result to your bank’s Retained Earnings on its Balance Sheet.

$354,650.00 - $234,112.50 = + $119,537.50

 Also, add Gain or Loss on Sold Loans to Retained Earnings. $0

 We assume the USD/EUR spot rate is unchanged.

Part B:

1. Construct the final balance sheet for your bank:

Balance Sheet t=4: End of Round 4

Assets Liabilities and Shareholders’ Equity

Cash $362,887.50 (=

$243,350.00 +

$119,537.50)

Deposits $6,000,000

Securities (T-Bills) $760,181.07 (=

$758,285.36 +

$1,895.71)

Borrowed Funds $4,000,000

Consumer Loans* $6.500,000.00 Eurodollar Borrowing $6,500,000

Residential

Mortgages*

$6.500,000.00 €-Denominated

Borrowed Funds

€851,923.08

(=$1,107,500.00 for

reporting purposes)

C&I Loans* $4,000,000.00 Total Liabilities $17,607,500.00

€-Denominated

C&I Loans:

€851,923.08

(=$1,107,500.00 for

reporting purposes)

Common Stock $1,000,000

Retained Earnings $623,068.57 (=$501,635.36

+ $119,537.50 + $1,895.71)

Total Shareholders’

Equity

$1,623,068.57

Total Assets $19,230,568.57 Total Liabilities and

Shareholders’ Equity

$19,230,568.57

Loans Sold: $0

*Loans figures are net of loan loss provisions.

2. Based on the balance sheet and net interest margin at the end of Round 4 conduct a financial analysis of

your bank. Calculate and discuss the following ratios in your analysis:

Equity capital to assets = $1,623,068.57/$19,230,568.57 = 0.08440

Tier 1 risk-based capital ratio = $1,623,068.57/($6,500,000.00 + $6,500,000.00 + $4,000,000.00 +

$1,107,500.00) = $1,623,068.57/$18,107,500.00 = 0.08964

Loss allowance to loans* ((0.04 x $6.500,000.00) + (0.02 x $6.500,000.00) + (0.01 x $4,000,000.00) +

(0.01 x $1,107,500.00))/ ($6.500,000.00 + $6.500,000.00 + $4,000,000.00 + $1,107,500.00)) =

$441,075.00/ $18,107,500.00 = 0.02436

*Loss provision or loan loss reserves are from Round 2-Part B and are also provided below. Assume euro-

denominated C&I loans have the same provision as domestic C& I loans.

Net interest margin ($354,650.00 - $234,112.50)/ $19,230,568.57 = $119,537.50/$19,230,568.57 = 0.00622

Return on assets = ($119,537.50 + $1,895.71)/$19,230,568.57 = $121,433.21/$19,230,568.57 = 0.00631

Return on equity = $121,433.21/$1,623,068.57 = 0.07482

Liquid assets- to-total deposits = ($362,887.50 + $760,181.07)/ $6,000,000 = $1,123,068.57/$6,000,000 =

0.18718

Net loans to deposits = (Loans – Loss Allowances to Loans)/ Deposits) ($18,107,500.00 -

$441,075.00)/$6,000,000 = $17,666,425.00/$6,000,000 = 2.94440x

Assess your bank’s performance and strength at the end of Round 4. Summarize any lessons learned from

the simulations rounds.

* Consumer Loans require a 4% loan loss reserve

--Residential Mortgages require a 2% loan loss reserve

--Commercial and Industrial (C&I) Loans require a 1% loan loss reserve