You are given that the duration of the commercial loan is 0.6042 years. You are given the following two assumptions.
a) The secondary market for an existing corporate loan is very liquid.
b) OUR Bank can issue a time-deposit for a fraction of a year.
With these two assumptions, the OUR Bank will have an investment horizon equal to the duration of the loan, that is 0.6042 years. For that, OUR bank will issue a time-deposit with a maturity equal to the duration of its loan.
Now, the balance sheet of OUR bank at time t=0 will look like following. At time t=0, the bank uses a hurdle rate (cost of capital) of 13.7606% per annum, continuously compounded for computing the future and present values for the cash flows of its loans, which we also call it the market interest (borrowing and lending) rate. Balance sheet as on t=0 (Now)
One-year commercial loan of $200 to be repaid in four equal quarterly installments; the interest payment is on the outstanding balance at an annual rate of 14% per annum.[Loan holding period equal to the Duration of loan]
|$200||Certificate of Deposit at 14% per annum simple interest; balloon payment of principal; maturity of deposit is equal to the duration of loan||$200|
a.What will be the net interest income or net cash flow or equity at the end of investment horizon of OUR Bank (end of duration of loan) if the market interest rate (reinvestment rate) for OUR Bank remains at 13.7606% continuously compounded throughout this one year.
b.What will be the net interest income or net cash flow or equity at the end of investment horizon of OUR Bank (end of duration of loan) if the market interest rate (reinvestment rate) for OUR Bank remains at 11.7606% continuously compounded throughout this one year. [In other words, after making the loan, the continuously compounded market interest rate (reinvestment rate) decreases by 200 basis points (2.000%) within the first quarter of the loan, and it remains at that level till the end of one-year.]
(Roundoff your final answer to at least four decimals)