6. A financial institution has the following market value balance sheet:

Assets Liabilities and Equity Cash $1,000 Certificate of Deposit $10,000 Bond $10,000 Equity $1,000 Total Assets $11,000 Total Liabilities and Equity $11,000

The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth.

a. What will be the net interest income (NII) at the end of the first year? Note: Net interest income equals interest income minus interest expense.

Interest income $1,000 $10,000 x 0.10 Interest expense 600 $10,000 x 0.06 Net interest income (NII) $400

b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?

Interest income $1,000 $10,000 x 0.10 Interest expense 700 $10,000 x 0.07 Net interest income (NII) $300

The decrease in net interest income is caused by the increase in financing cost without a corresponding increase in the earnings rate. Thus, the change in NII is caused by refinancing risk. The increase in market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten years. Note: this answer makes no assumption about