6-11.

What are the principal components of ROE, and what does each of these components
measure?
The principal components of ROE are:
a. The net profit margin or net after-tax income to Total operating revenues which reflects the
effectiveness of a bank's expense control program and service pricing policies;
b. The degree of asset utilization or ratio of Total operating revenues to Total assets which
measures the effectiveness of managing the bank's portfolio management policies, especially the
mix and yield on assets; and,
c. The equity multiplier or ratio of Total assets to Total equity capital which measures a bank's
use of leverage in funding its operations: sources chosen to fund the financial institution (debt or
equity).
6-16. To what different kinds of risk are banks and their financial-service competitors subjected
today?
a. Credit Risk - the probability that the loans and securities the bank holds will not pay out as
promised.
b. Liquidity Risk - the probability that the bank will not have sufficient cash on hand in the
volume needed precisely when cash demands arise.
c. Market Risk - the probability that the market value of assets held by the bank will decline due
to falling market prices.
d. Price Risk the probability or possibility that the value of bond portfolios and stockholders
equity may decline due to market prices movement against the financial firm.
e. Interest-Rate Risk - the possibility or probability that the interest rates will change, subjecting
the bank to lower profits or a lower value for the firms capital.

6-9. Watson County National Bank presents us with these figures for the year just concluded.
Please determine the net profit margin, equity multiplier, asset utilization ratio, and ROE.
Net income = $25
Total operating revenues = $135
Total assets = $1,700
Total equity capital accounts = $160
a.

Net Profit Margin

Net Income

Total Operating Revenue

Asset Utilization

= Total Operating Revenues

Total Assets

c.

Equity Multiplier

= $135 mill.
$1700 mill.

Total Equity Capital

d.

7-10

ROE

Net Income
Total Equity Capital

= 0.1852 or 18.52%

$135 mill.

b.

Total Assets

$25 mill.

$1700 mill.

= 0.0794 or 7.94%

= 10.63 times

$160 mill.
=

$25 mill.
$160 mill.

= 0.1563 or 15.63 %

When is a financial firm asset sensitive? Liability sensitive?

A financial firm is asset sensitive when it has more interest-rate sensitive assets maturing or
subject to repricing during a specific time period than rate-sensitive liabilities. A liability
sensitive position, in contrast, would find the financial institution having more interest-rate
sensitive deposits and other liabilities than rate-sensitive assets for a particular planning period.
7-19. How can you tell you are fully hedged using duration gap analysis?
You are fully hedged when the dollar weighted duration of the assets portfolio of the bank equals
the dollar weighted duration of the liability portfolio. This means that the bank has a zero
duration gap position when it is fully hedged. Of course, because the bank usually has more
assets than liabilities the duration of the liabilities needs to be adjusted by the ratio of total
liabilities to total assets to be entirely correct.

7-21. Suppose that a thrift institution has an average asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds total assets of $560 million and total liabilities of
$467 million, does it have a significant leverage-adjusted duration gap? If interest rates rise, what
will happen to the value of its net worth?
Liabilities
Assets

Duration Gap = DA DL *
= 2.5 yrs. 3.0 yrs.
= 2.5 years 2.5018 years
= -0.0018 years

$467 million

$560 million

This bank has a very slight negative duration gap; so small in fact that we could consider it
insignificant. If interest rates rise, the bank's liabilities will fall slightly more in value than its
assets, resulting in a small increase in net worth.
7-16 Blue Moon National Bank holds assets and liabilities whose average durations and dollar
amounts are as shown in this table:
Asset and Liability Items
Investment Grade Bonds
Commercial Loans
Consumer Loans
Deposits
Nondeposit Borrowings

Avg.Duration(yrs)
12.00
4.00
8.00
1.10
0.25

$ Amount
$65.00
$400.00
$250.00
$600.00
$50.00

What is the weighted average duration of New Phases asset portfolio and liability portfolio?
What is the leverage-adjusted duration gap?
D A Wi * D i

65
400
250
* 12
*4
* 8 1.0909 2.2378 2.7972 6.13 years
715
715
715

D L Wi * D i

600
50
*1.1
* 0.25 1.0154 .0192 1.03 years
650
650

Duration Gap D A D L *

TL
650
6.13 1.03 *
5.19
TA
715