A Small Dutch Bank Has the Following Balance Sheet (In

question 30

Essay

A small Dutch bank has the following balance sheet (in euros), based on historical or nominal values.
$\begin{array}{cl}\text { Assets } &{\text { Liabilities }} \\\hline \text { Loan of } 200 \text { million: } & \text { FRN borrowing of } 150 \text { million: } \\3 \text { years, @ 7\% } & \text { @ 3-month Euribor, 5-year maturity } \\& \text { Net worth: } 50 \text { million }\end{array}$ All assets and liabilities are denominated in euros. The bank borrows short-term on the Euro-currency market. The bank and its client are AAA quality. The net worth is calculated as the difference between the value of assets and liabilities. The current euro term structure for AAA borrowers is flat at 6.5%.
a. Value the balance sheet based on market value.
b. Compute the interest-rate sensitivity (duration) of the asset. Infer the interest rate sensitivity of the net worth of the bank. For example, how much would stockholders lose if euro interest rates moved up by 0.10%? (Assume that the interest rate sensitivity of an floating-rate note (FRN) is zero, as the coupon is reset to the market interest rate.)
c. The bank fears a rise in all euro interest rates. The current market conditions for interest rate swaps in euros are as follows:
$\bullet$ With a maturity of three years are: 6.5% against Euribor.
$\bullet$ With a maturity of five years are: 6.75% against Euribor.
What would you do to hedge this interest rate risk?
d. The next day, all interest rates move up to 8%. Value again the balance sheet, assuming that the floating-rate debt remains at 100% and that the bank has undertaken the swap that you recommended. Is the hedge perfect? Why?

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