Question 1:

Part i:
Now first of all let us view at the cash flows of Projects S & R
Project S
Year 0 1 2

CFs -300 590 With probability

0.8

200 With probability

0.2

In Year 2, there are two probable estimated cash flows 2: 590 with a probability of 0.8 and 200
with a probability of 0.2. So, based on their relative probabilities, the estimated cash flow in Year
2 will be = 590*0.8 + 200*0.2 = 512.

The following are the expected cash flows:

Year 0 1 2

CFs -300 512

Project R
Year 0 1 2

CFs -300 670 With probability

0.6

50 With probability
0.4
There are also two probable estimated cash flows in Year 2: 670 with a likelihood of 0.6 and 50
with a likelihood of 0.4.

So, the expected cash flow in Year 2 considering their respective probabilities will be = 670*0.6
+ 50*0.4 = 422
So the estimated cash flows are:

Year 0 1 2

CFs -300 422

Interest Rates
The Single Period Interest Rate (for t=0) = 3%

The Single Period Interest Rate (for t=1) = 5% (with probability 60%) &

9% (with probability 40%)

So, the expected Interest Rate (for t=1) = 0.05*0.60 + 0.09*0.40 = 6.6%
Analysis of the available options to the Borrower
In both of the projects S and R, the capital investment is the same. Which is $300 at t=1 from
now. But the estimated cash inflow are different. For S, it is $ 512 at t=2 and for R, it is $422 at
t=2.

It is evident that investing in Project S is more profitable than R because on equal initial

investments at t=0, the expected cash flow at t=2, the profit is greater in case of project S than in
case of Project R.
So, the first thing we can conclude is that project S is profitable than project R

(i) Calculating NPV of Project S at t=1

We will suppose to be in t=1 and discount the cash flows using the prevailing Interest Rate is
6.6%.
Therefore, the NPV at t=1 will be:

= -300 + 512/(1+ 0.066)^1 = $ 180.3

(ii) NPV of Project R at t=1

Again using the same discounted cash flows but this time at t=1 at the same prevailing interest
rate=6.6 %

The NPV at t=1 will be = -300 + 422/(1+ 0.066)^1 = $ 95.87

Project S will clearly be more profitable, regardless of the discount rate used, due to its higher
cash inflows.

At this point the borrower has two choices:

(i) To do nothing at t=0 and borrow at prevailing interest rate 6.6% at t=1.

(ii) Negotiate with the bank for a commitment to borrow at time t=1 on predetermined terms.

At t=1, the prevailing spot rate would be 6.6%, which we have calculated earlier using different
probabilities given in the question. And the current Interest rate is 3%.
As a result, the borrower's advice will be to try to negotiate with the bank to secure a
commitment to lend at t=1 at a rate lower than the Spot Rate at t=1, i.e. 6.6 percent.
The lending rate at which the bank will lend to the borrower at t=1 should be higher than 3% but
lower than 6.6% for the agreement to be beneficial to both parties, i.e. the bank and the borrower.

Benefit for the Borrower

In the absence of any pre-commitment from the bank, the benefit to the borrower will be that the
interest rate on his loan will be lower than the predicted interest rate at t=1. He will be supposed
to pay less than 6.6%.
Part ii.

Question 2:
The formula for variance of return
P1,2=Cov1,2/σ1σ2
=195,000,000-145,000,000/(9 % * 9%)
=6,172,839,506.17
Therefore, the firm’s variance of return is 6,172,839,506.17
Fair interest rate=Interest rate *100/(variance return *no of years)
=9% * 100/(6,172,839,506.17*5)
So FIR=8.99 %
Therefore, FIR is 8% <8.99% > 10 %
Question 3:
Duration of special loan
Yield to maturity= 4.5 % per annum

CFs Present value

123.25 117.84
0 0
0 0
575.25 480.65
285 227.67
150 114.56
Total: 940.73

Weight x Duration
117.84/940 *1 = 0.125
480.65/940 *4 = 2.045
227.67/940 * 5 = 1.21
114.56/940 * 6 = 0.731
By adding all these years
Total no of years = 4.11 years
So duration of special loans = 4.11 years

Duration of variable loans

Duration of variable loans is 6 months or 180 days. The variable loan is repriced 180 days.
The principle is that duration of variable loan < special loan.
Since the loan interest rate is repriced every 6 months on the outstanding loan balance therefore,
payment will vary every 180 days.

3 Years swap
The principle for the swap would be equal to the amount of variable loan
Hence, the bank prefers to be a floating payer and fixed receiver of the interest therefore, the
bank has the obligation to pay fixed interest on its debts and deposits.

If a financial institution enters into a three year swap with another financial institution. Also, it
agrees to pay floating interest rate of on national principle and receive 4.5 % interest rate every
year on national principle.
As the interest rate if generally structured so one side omits the difference between the two
payments to the other side.
Let’s suppose interest rate is 4.5 % per annum, so then both the institution pay 4.5%*950 = $33
million. As both pay the same amount so the different become zero.
If there difference is not equal to zero in any other case, then one financial institution will pay
that amount to another financial institution.

Question 4:
To find equity, we need the equation Assets=Equity + liabilities
Assets=1545, liabilities=1420
Equity=Assets-Liabilities
Equity=125
After that, we'll need to figure out duration of assets. The weighted average duration of the
bank's various assets will be the duration of assets and same for the liabilities as well.
The table below shows the calculations, All are financials are in $ million.

Asset Amount Weight Duration Weight*Duration

A W=A/Total A D W*D
 Cash 340 22% 0 0
Treasury Bills 120 7.8% 0.25 yrs 0.0195
Loans (hybrid) 500 32.4% 1.75 yrs 0.567
Loans (variable) 310 20% 0.5 yrs 0.1
Loans (fixed) 275 17.7% 3.5 yrs 0.619
Total 1545 100% 1.306
Liabilities Amount Weight Duration Weight*Duration
B W=B/Total B D W*D
Core Deposits 350 24.6% 1.5 yrs 0.369
Euro CDs 495 35% 1.0 yrs 0.35
Debentures A 300 21.1% 3.0 yrs 0.633
Debentures B 275 19.3% 5.0 yrs 0.965

Total 1420 100 2.317

A = Total assets = $ 1545 million

L = Total liabilities = $ 1420 million

Duration of assets, DA = 1.306

Duration of liabilities, DL= 2.317

k = L/A = 1420 / 1545 = 0.919

The benchmark 20-year, 8% coupon bond serves as the underpinning for bank bill futures
contracts, with a minimum contract value of $100,000 and a 9.5-year delivery bond period.
There is no basis risk because the 90-day bank bill futures are quoted at 97.0.
F = Bond to be delivered against futures contracts has a duration of 9.5 years.
PF = price of the future contract = quoted price x contract size = 97 percent x 100,000 = 97,000.

Hence, number of future contracts to be sold = N F = (DA - k x DL) x A / (DF x PF) = (1.306 -
0.919 x 2.317) x 1,545,000,000 / (9.5 x 97,000) = 296.2 = 296 contracts
The contracts are needed to be sold so short position would be recommended.
Question 5:
Proposals to force some banks to issue a standardised type of subordinated debt have prompted
current market discipline debates. Bank subordinated debt, like any business bond, pays interest
over time and pays the principal at maturity. Unlike many other bonds, this one is
"subordinated," meaning that if the bank fails, the holders will be paid after insured depositors,
uninsured depositors, and general creditors. The FDIC does not insure subordinated debt since it
is not backed by collateral. "Standardized" debt adheres to pre-determined terms to maturity and
issuance frequencies. Banks, for example, may be forced to sell a certain number of five-year
instruments each year. The majority of suggestions stipulate that total subordinated debt
outstanding must account for a small percentage of a bank's total funding. To make subordinated
debt mandatory, bank regulators would have to first develop a rule outlining the standardised
conditions and publish it for public review. Supervisors could then publish the rule as a legally
binding bank regulation after responding to these comments.
Although most economists think mandatory subordinated debt is a good idea in theory, they
disagree on how to put it into practise. Even among supporters of mandatory subordinated debt,
for example, there are disputes over the amount of subordinated debt that large banks should be
obliged to issue. There are also disagreements about whether the mandate should apply to the
bank or the bank holding company. Finally, there are disagreements about whether the debt
should be long- or short-term. To put it another way, supervisors will have to learn to think like
market analysts while keeping in mind the difference between protecting the economy from bank
failures and optimising projected returns for security holders.

Question 6:

The above statement is correct.

On a variable rate credit product, a cap is an interest rate limit. It is the highest rate that a
borrower can be charged, as well as the highest rate that a creditor can earn. The details of an
interest rate cap shall be disclosed in a lending contract or an investment prospectus.
Borrowers benefit from the cap since it reduces the amount of interest they must pay in
increasing rate conditions.

If a product has a capped rate, the interest rate will rise in lockstep with the indexed rate until the
maximum is reached.

Given the Scenario

The loan with a 4.5 percent interest rate cap should be stable than a loan with a 6 percent interest
rate cap. While the value of the latter loan can increase by up to 6%, the value of the former can
only increase by 4.5 percent. As a result, the 4.5 percent interest rate cap loan is more stable.

Question 7:

i. The financial institutions have a single hedge fund manager who applies a variety of
on-balance and off-balance techniques. The hedge in a balance sheet requires the
position of matching currency and the time of the assets and liabilities.

ii. The bank is exposed to risk credit because the quality of the borrower's credit can
decrease during the loan commitment period. When banks make a loan commitment,
they have a legal obligation to deliver the loan. All loan commitments include a
condition that allows banks to be released from their obligations if credit quality
decreases.

iii. The risk rate of interest is linked to the risk of credit since the risk of default is higher
when the rate of interest increases. Companies have more return dates as the rate of
interest decreases. As a result, banks also make loan commitments that are tied to
both time periods of growing interest rates.

Question 8:
The world has experienced an unusual period of low interest rates since 2008. The central bank
of a country uses interest rates as a main tool of monetary policy to boost investment,
employment, and inflation. Poor interest rates, according to the theory, encourage more spending
and investment due to the opportunity cost effect of low returns on cash savings accounts.
What are negative interest rates and how do they work? In practise, this means that lenders
compensate borrowers for the pleasure of receiving their funds. This may appear to be a little
deceptive, but it is a reflection of the current economic situation, which is characterised by an
excess of money supply and a lack of investment demand.

Negative interest rates should theoretically have many of the same expansionary impacts as
interest rate decreases in a normal positive rate environment. It should boost spending and
investment while also assisting in the stabilisation of asset prices (and the stock market). In
practice, though, there are unexpected effects. The financial system has been harmed as a result
of extended periods of low or negative interest rates. Because net interest margin - the difference
between interest income made on loans and interest paid out on deposits – is so important to
banks' profits. Because of political sensitivity and intense rivalry for deposits, the interest rates
they pay on deposits are typically higher than zero. In a declining rate environment, however,
banks would charge lower interest rates on new loans to borrowers. As a result, banks' net
interest margins would decrease. Not to mention that the situation can get more complicated
during periods of high uncertainty. Banks have increased their provisions for non-performing
loans ("NPLs") and are facing increased impairment risks in their loan portfolios. Negative
interest rates would be damaging to the profitability of banks in general.

Falling rates should, theoretically, make higher-risk investments like equities more attractive
than fixed-income assets. Low interest rates, on the other hand, may have limited benefits for the
Singapore stock market. It is critical to consider context while attempting to comprehend the
influence of a new occurrence on the stock market. The prospect of weaker local bank
profitability would weigh on the Singapore stock market, which is heavily tilted towards the
financial sector: According to the latest ("SGX") Market Statistic Report from April 2020, the
market capitalisation of just three local banks (DBS, OCBC, and UOB) totaled $124.3 billion,
accounting for more than 15% of the overall market capitalization of $802.2 billion in Singapore.

Low interest rates may benefit property stocks and Real Estate Investment Trusts ("REITs"),
which account for 12% of Singapore's total listed stocks. SREITs stand to gain from the
additional debt headroom as well as refinancing at reduced interest rates as a result of new
measures allowing them to increase their gearing ratio from 45 percent to 50 percent to deal with
the Covid-19 repercussions. Find out more about the Phillip Singapore Real Estate Income Fund
or the Lion-Phillip S-REIT ETF if you're interested in S-REITs.