Final answer:
The net worth of the financial institution decreases as interest rates rise from 10% to 11%, given the difference in durations between assets and liabilities. This is calculated using duration gap analysis and reflects the general impact that rising interest rates have on financial institutions with longer-term assets.
Step-by-step explanation:
The student is asking about the impact of an interest rate increase on the net worth of a financial institution (FI), given certain financial parameters. The question involves calculating the net worth change using the concepts of duration of assets (D(A)) and liabilities (D(L)), and the effect of an interest rate increase from 10% to 11%. To analyze the situation, we consider the FI's assets and liabilities, where D(A) is 5 years, D(L) is 3 years, liabilities are worth 90, and equities (or net worth) are 10. We apply the Macaulay duration gap analysis to determine the effect of interest rate change on the FI's net worth.
When interest rates rise, the present value of future cash flows of assets and liabilities changes. As a general rule, assets with longer durations decrease more in value than liabilities with shorter durations, leading to a decrease in net worth. This will be particularly the case for financial institutions holding more long-term fixed-income assets sensitive to interest rate changes.
In the broader context, considering government borrowing and financial markets, increased government borrowing can lead to a shift in the demand for financial capital, consequently raising interest rates and potentially crowding out private investment, as observed in the provided figures and situations.