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SOLUTION QUIZ 3 1. Confidence Bank has made a loan to Risky Corporation. The loan terms include a default free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves at the Fed are 6 percent. What is the expected or promised gross return on the loan? a. 11.19 percent b. 11.90 percent c. 12.29 percent d. 12.02 percent e. 12.22 percent risk- 2. Use the following information on spot and forward term structures for questions 98-102. (1 year maturity) Spot 1 Year Spot 2 Year Forward 1 Year Treasury 3.0 percent 4.75 percent x BBB Corporate Debt 7.5 percent 9.15 percent y 11-98 Calculate the value of x (the implied forward rate on one-year maturity Treasuries to be delivered in one year). a. 6.53 percent. b. 10.83 percent c. 5.75 percent d. 6.925 percent e. 1.017 percent 11-99 Calculate the value of y (the implied forward rate on one-year maturity BBB corporate debt to be delivered in one year). a. 6.53 percent. b. 10.83 percent c. 5.75 percent d. 6.925 percent e. 1.017 percent 11-100 Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the current year is a. 98.0 percent b. 2.35 percent c. 4.19 percent d. 3.90 percent e. 2.71 percent 11-101 Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the following year is a. 4.20 percent b. 98.0 percent c. 2.35 percent d. 2.71 percent e. 3.88 percent 11-102 The cumulative probability of repayment of BBB corporate debt over the next two years is a. 99.84 percent b. 90.00 percent c. 4.45 percent d. 95.70 percent e. 100.0 percent 3. Use the following information and option valuation model for problems 110-111. Onyx Corporation has a $200,000 loan that will mature in one year. The risk free interest rate is 6 percent. The standard deviation in the rate of change in the underlying asset’s value is 12 percent, and the leverage ratio for Onyx is 0.8 (80 percent). The value for N(h1) is 0.02743, and the value for N(h2) is 0.96406. 11-110 What is the current market value of the loan? a. $160,000 b. $188,041 c. $200,000 d. $188,352 e. $178,571 11-111 What is the required yield on this risky loan? a. 6.165 percent b. 6.00 percent c. 0.165 percent d. 5.835 percent e. None of the above. 4. Identify and define the borrower-specific and market-specific factors that enter into the credit decision. What is the impact of each type of factor on the risk premium? The borrower-specific factors are: Reputation: Based on the lending history of the borrower; better reputation implies a lower risk premium. Leverage: A measure of the existing debt of the borrower; the larger the debt, the higher the risk premium. Volatility of earnings: The more stable the earnings, the lower the risk premium. Collateral: If collateral is offered, the risk premium is lower. Market-specific factors include: Business cycle: Lenders are less likely to lend if a recession is forecasted. Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions. 5. 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 premium measured? What precisely is LN in the RAROC equation? RAROC is a measure of expected loan income in the form of interest and fees relative to some measure of asset risk. One version of the RAROC model uses the duration model to measure the change in the value of the loan for given changes or shocks in credit quality. The change in credit quality (R) is measured by finding the change in the spread in yields between Treasury bonds and bonds of the same risk class on the loan. The actual value chosen is the highest change in yield spread for the same maturity or duration value assets. In this case, LN represents the change in loan value or the change in capital for the largest reasonable adverse changes in yield spreads. The actual equation for LN looks very similar to the duration equation. RAROC Net Income R where LN DLN x LN x where R is the change in yield spread . Loanrisk (or LN ) 1 R 6. What are compensating balances? What is the relationship between the amount of compensating balance requirement and the return on the loan to the FI? A compensating balance is the portion of a loan that a borrower must keep on deposit with the creditgranting depository FI. Thus, the funds are not available for use by the borrower. As the amount of compensating balance for a given loan size increases, the effective return on the loan increases for the lending institution. 7. Why are most retail borrowers charged the same rate of interest, implying the same risk premium or class? What is credit rationing? How is it used to control credit risks with respect to retail and wholesale loans? Most retail loans are small in size relative to the overall investment portfolio of an FI, and the cost of collecting information on household borrowers is high. As a result, most retail borrowers are charged the same rate of interest that implies the same level of risk. Credit rationing involves restricting the amount of loans that are available to individual borrowers. On the retail side, the amount of loans provided to borrowers may be determined solely by the proportion of loans desired in this category rather than price or interest rate differences, thus the actual credit quality of the individual borrowers. On the wholesale side, the FI may use both credit quantity and interest rates to control credit risk. Typically, more risky borrowers are charged a higher risk premium to control credit risk. However, the expected returns from increasingly higher interest rates that reflect higher credit risk at some point will be offset by higher default rates. Thus, rationing credit through quantity limits will occur at some interest rate level even though positive loan demand exists at even higher risk premiums.