A Small French Bank Has the Following Balance Sheet, Based

question 10

Essay

A small French bank has the following balance sheet, based on historical (nominal) values.
$\begin{array}{cl}\text { Assets } &{\text { Liabilities }} \\\hline \text { Loan of } 100 \text { million: } & \text { Debt of } 50 \text { million: } \\3 \text { years, @ 3-month Euribor }+1 / 2 & \text { 5-year maturity, @ 10\% } \\& \text { Net worth: } 50 \text { million }\end{array}$
All assets and liabilities are denominated in euros. The net worth is calculated as the difference between the value of assets and liabilities. The current interest rate term structure in euro is flat at 8%. The risk premium over Euribor required on the loan to a client remains at 50 basis points.
a. Value the balance sheet based on market value.
b. The bank anticipates a sharp drop in French interest rates. Would this drop be good for the bank?
The current market conditions for interest rate swaps with a maturity of three or five years are 8% against Euribor.
c. Assume that the bank simply wishes to immunize its market value against any movements in interest rates (drop or rise). What swap would you make to hedge this interest rate risk?
d. Assume that the bank is quite confident in its interest rate prediction (a drop). What would you suggest?
The next day, all interest rates drop to 7%.
e. Value the balance sheet again, assuming that the floating rate debt remains at 100% and that the bank has undertaken the swap that you recommended. How much did the bank save by undertaking this swap?

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