Question

Assets Liabilities Short Term Loans 1000 5-year CDs 1350 Long-Term Loans 500 Net Worth 150 The short-terms loans are zero coupon and repaid at the end of 1 year. The Long-term loans are zero coupon loans that mature in 3 years. On the liability side, the 5-year CDs are also zero coupon. Assume that the yield curve is flat and interest rates are 5% today. Suppose you want to duration hedge the bank’s equity by buying a 10-year Treasury STRIP financed with overnight borrowing in the interbank market. How would you hedge against a 1% increase in interest rates using STRIPS?

a) Long 425 million
b) Short 425 million
c) Long 500 million
d) Short 500 million
e) Long 375 million

Answer 1

The bank's equity hedging question cannot be definitively answered without specific detail on the duration of assets and liabilities. A 5-year CD at 2% interest, compounded annually, will have a future value calculated using the compound interest formula. Start-up firms commonly raise financial capital through methods such as bootstrapping, angel investors, venture capital, crowdfunding, and small business loans.

Step-by-step explanation:

The question pertains to a scenario where a bank is trying to duration hedge its equity against an interest rate increase by using Treasury STRIPS. To determine how to hedge against a 1% increase in interest rates using STRIPS (Separate Trading of Registered Interest and Principal Securities), one would need to calculate the duration of the bank's net worth and then use STRIPS with a matching duration to offset this. However, since the question does not provide sufficient details to perform these calculations (such as the amount of equity and the specific durations of the assets and liabilities), it is not possible to provide a concrete answer like 'Long 425 million' or 'Short 425 million'. Instead, the methodology would involve determining the duration of the bank's assets and liabilities and then transacting in an amount of STRIPS with a matching or offsetting duration to immunize the net worth against interest rate changes.

When you open a 5-year CD for $1,000 that pays 2% interest, compounded annually, you can calculate the future value of the CD using the formula for compound interest: F = P(1 + r/n)nt, where P is the principal, r is the annual interest rate, n is the number of times the interest is compounded per year, and t is the number of years. Plugging in the values, the future value of the CD after 5 years would be: F = $1,000(1 + 0.02/1)1*5 = $1,000(1.02)5, which would give you the future value of the CD.

Common ways for start-up firms to raise financial capital include bootstrapping, angel investors, venture capital, crowdfunding, and small business loans. Each method offers different benefits and trade-offs in terms of control, equity, and repayment terms for the start-up firm.