1. (think question) On pages 302-303, forward rate calculation is presented. Then the probability of default calculation is presented. Let’s suppose the yield on a 2-year T-bond strip is .04 and the 1-year T-bond strip is .03. Also, suppose that the corporate 2-year bond annual rate is .08 and the 1-year corporate bond rate is .065.
a. calculate the probability of default in year 2 for the corporate bond.
b. Note all the reasons that you can think of that this calculation will give us a poor estimate of the probability of default in year 2. In other words, why might it be very risky to rely on that probability calculation?
2. What are the ways a credit officer might use to determine if a loan to a corporation had credit risk?
3. Your business wants to borrow $2 million. How might you go about reducing the credit risk to get a lower interest rate on the loan. List anything that is appropriate.
4. (think question) Chapter 11 on Credit Risk has a nice application of the variance of a portfolio. The appendix 11B has a nice application of probability using a Poisson distribution. Statistics are generated on past data. How does a rare event like the sub-prime mortgage fiasco impact on a bank’s estimation of its risk?
5. How can a bank become illiquid? In other words, what are circumstances that lead to illiquidity?