A bank is planning to make a loan of $2,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 75 basis points. The loan has a maturity of 6 years with a duration of 5.25 years. The return on equity (ROE) for the bank is 18 percent. The bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 5.75 percent, based on two years of historical data. The current market interest rate for this sector less the cost of funds (ROE) is 3.5 percent.
1. What is the Risk Adjusted Return on Capital (RAROC)? Should the bank make this loan?
2. What should the duration be in order to accept this loan?
3. Assuming duration cannot be changed, how much additional fee income will need to be charged?