Answer the following question given below:
1. Why is credit risk analysis an important component of FI risk management? What recent activities by FIs have made the task of credit risk assessment more difficult for both FI managers and regulators?
2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?
3. How does a spot loan differ from a loan commitment? What are the advantages and disadvantages of borrowing through a loan commitment?
4. What are the primary characteristics of residential mortgage loans? Why does the ratio of adjustable-rate mortgages to fixed-rate mortgages in the economy vary over an interest rate cycle? When would the ratio be highest?
5. Why are rates on credit card loans generally higher than rates on car loans?
6. County Bank offers one-year loans with a stated rate of 9 percent but requires a compensating balance of 10 percent. What is the true cost of this loan to the borrower? How does the cost change if the compensating balance is 15 percent? If the compensating balance is 20 percent? In each case, assume origination fees and the reserve requirement are zero.
7. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25 percent loan origination fee, imposes a 10 percent compensating balance requirement, and must pay a 6 percent reserve requirement to the Federal Reserve. The loans typically are repaid at maturity.
a. If the risk premium for a given customer is 2.5 percent, what is the simple promised interest return on the loan?
b. What is the contractually promised gross return on the loan per dollar lent?
c. Which of the fee items has the greatest impact on the gross return?
8. Why could a lender's expected return be lower when the risk premium is increased on a loan? In addition to the risk premium, how can a lender increase the expected return on a wholesale loan? A retail loan?
9. What are covenants in a loan agreement? What are the objectives of covenants? How can these covenants be negative? Positive?
10. Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X1 + .02X2 - .05X3 + error, where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower earnings, and X3 = 0.10 is the borrower's profit ratio. For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 = 0.10.
a. What is the projected probability of default for the borrower?
b. What is the projected probability of repayment if the debt/equity ratio is 2.5?
c. What is a major weakness of the linear probability model?
11. Describe how a linear discriminant analysis model works. Identify and discuss the criticisms which have been made regarding the use of this type of model to make credit risk evaluations.
12. MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the following financial information in its application for a loan. All numbers are in thousands of dollars.
a. What is the Altman discriminant function value for MNO, Inc.? Recall that:
b. Should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan?
c. If sales for MNO were $300,000, the market value of equity was only half of book value, and the cost of goods sold, interest, and tax rate were unchanged, what would be the net income for MNO? Assume the tax credit can be used to offset other tax liabilities incurred by other divisions of the firm. Would your credit decision change?
d. Would the discriminant function change for firms in different industries? Would the function be different for manufacturing firms in different geographic sections of the country? What are the implications for the use of these types of models by FIs?
13. A bank has made a loan charging a base lending rate of 10 percent. It expects a probability of default of 5 percent. If the loan is defaulted, the bank expects to recover 50 percent of its money through the sale of its collateral. What is the expected return on this loan?
14. Calculate the term structure of default probabilities over three years using the following spot rates from the Treasury strip and corporate bond (pure discount) yield curves. Be sure to calculate both the annual marginal and the cumulative default probabilities.
15. The bond equivalent yields for U.S. Treasury and A-rated corporate bonds with maturities of 93 and 175 days are given below:
93 Days 175 Days
U.S. Treasury 8.07% 8.11%
A-rated corporate 8.42% 8.66%
Spread 0.35% 0.55%
a. What are the implied forward rates for both an 82-day Treasury and an 82-day A-rated bond beginning in 93 days? Use daily compounding on a 365-day year basis.
b. What is the implied probability of default on A-rated bonds over the next 93 days? Over 175 days?
c. What is the implied default probability on an 82-day A-rated bond to be issued in 93 days?
16. What is RAROC? How does this model use the concept of duration to measure the risk exposure of a loan? How is the expected change in the credit risk premium measured? What precisely is ?LN in the RAROC equation?
17. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent.
a. Using the RAROC model, determine whether the bank should make the loan?
b. What should be the duration in order for this loan to be approved?
c. Assuming that duration cannot be changed, how much additional interest and fee income will be necessary to make the loan acceptable?
d. Given the proposed income stream and the negotiated duration, what adjustment in the loan rate would be necessary to make the loan acceptable?
18. A firm is issuing a two-year debt in the amount of $200,000. The current market value of the assets is $300,000. The risk-free rate is 4 percent and the standard deviation of the rate of change in the underlying assets of the borrower is 20 percent. Using an options framework, determine the following:
a. The current market value of the loan.
b. The risk premium to be charged on the loan.
Academic requirements:
• Your work must be submitted as pages 7 - 9 of pages
• Your work should be submitted in the formats outlined for each questionin the assignment.