Chapter 30, Problem 12P

You have been hired as a risk manager for Acorn Savings and Loan. Currently, Acorn’s balance sheet is as follows (in millions of dollars):

When you analyze the duration of loans, you find that the duration of the auto loans is two years, while the mortgages have a duration of seven years. Both the cash reserves and the checking and savings accounts have a zero duration. The CDs have a duration of two years and the long-term financing has a 10-year duration.

1. a. What is the duration of Acorn’s equity?
2. b. Suppose Acorn experiences a rash of mortgage prepayments, reducing the size of the mortgage portfolio from $150 million to $100 million, and increasing cash reserves to $100 million. What is the duration of Acorn's equity now? If interest rates are currently 4% but fall to 3%, estimate the approximate change in the value of Acorn’s equity.
3. c. Suppose that after the prepayments in part (b), but before a change in interest rates, Acorn considers managing its risk by selling mortgages and/or buying 10-year Treasury STRIPS (zero-coupon bonds). How many should the firm buy or sell to eliminate its current interest rate risk?