Assignment Task:
1. Lehman Sisters initially has the fol owing balance sheet:
Assets Liabilities Total reserves 150 Deposits 1000 Loans 950 Borrowings 300 Mortgages 200 Bank capital? Securities 200
Please answer the following questions (a-f). The questions are in sequence, meaning that b follows on a, c follows on b, etc. Show your work.
a. Explain in words what bank capital is. Now, much bank capital has Lehman Sisters?
b. The desired reserve ratio at this bank is 10%. Now depositors deposit an additional 100 to the bank. Give the new balance sheet; separately show desired reserves and excess reserves on this balance sheet.
c. Now the coronavirus hits the markets and the securities halve in value (i.e., lose 50% of their original value). The regulator forces the bank to sell all its securities. List the balance sheet items that will change as a consequence. Give the previous value, the change, and the resulting new value.
d. Now depositors become worried about the financial situation of the bank. They decide to withdraw 200. What is the effect on the bank’s reserve ratio? Please give the computation.
e. What can the bank do to increase the reserve ratio to the desired level (i.e., 10%)? Which balance sheet entries would change, and by how much? (It is not needed to give the full balance sheet.)
f. The regulator finds the capital ratio too low and requires an increase in this ratio. Lehman Sisters does not want to antagonize its shareholders by issuing new capital or decreasing dividends. What is the most likely course of action that the bank will take to improve its capital ratio? How will that change the assets and the liabilities on the balance sheet? Please explain in words. (No need to give the full balance sheet, just give the likely changes.)
2.JP Morning bank has a considerable number of bond securities on its balance sheet. It is worried about changes in the interest rate and would, therefore, like to engage in bond futures contracts.
a. Should the bank be worried about interest increases or decreases? What type of bond futures contract would you recommend (long or short)?
For the remainder of this question, assume that the bank has just 1 bond with a current bond price of 100. Ignore the existence of multipliers on future contracts, so that one future contract has one bond as an underlying asset.
b. If you would draw the payoff lines for the bond and for the futures contracts, how would both lines look like?
The payoff line representing the bonds is an upward /downward sloping line. The payoff line for the bonds does go /does not go through the origin. The payoff line for the futures contract is an upward /downward sloping line. The payoff line for the futures contract does go /does not go through the origin.
c. If both the bond price and the futures price go down by 1 (i.e., bonds from 100 to 99 and futures from 105 to 104), how does that affect the value of the combined portfolio? Please give the computation (you do not have to show it in the graph).
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