Chapter 10 Testbank Key

 1. A loan provided by a group of FIs as opposed to a single lender is called:

A.  a joint loan
B.  project finance
C.  a syndicated loan
D.  a multiple loan
 2. ... is a debt security issued by a corporation and sold to investors.
 A. A corporate bond
B. A company bond
C. A firm bond
D. A corporate paper

3. A corporate bond is:

A.  a bond issued by governments and sold to corporations
B.  a bond hold by corporations
C.  a debt security issued by a corporation and sold to investors
D.  None of the listed options are correct.

 4. The term 'loan rating' refers to the process of individual loans being given credit rating by:
A.  rating agencies dependent on the lender's credit assessment
B.  rating agencies independent of the lender's credit assessment
C.  lenders dependent on a credit rating agency's credit assessment
D.  lenders independent of a credit rating agency's credit assessment
 
5. The term 'asset-backed loan' refers to a loan that is backed by a:
A.  first claim on certain assets of the borrower if default occurs
B.  second claim on certain assets of the borrower at maturity
C.  first claim on certain assets of the borrower at maturity
D.  None of the listed options are correct.

6. An unsecured loan is also referred to as:

A.  a non-asset backed loan
B.  mezzanine debt
C.  junior debt
D.  senior debt

 7. The term 'spot loan' refers to a loan:

A.  that is granted on the spot
B.  that needs to be repaid on the spot
C.  granted at the spot rate
D.  for which the full loan amount is withdrawn by the borrower on the spot
 
8. Which of the following statements is true?
A.  A line of credit facility is a credit facility with a maximum size and a minimum period of time over which the borrower can
withdraw funds.
B.  A line of credit facility is a credit facility with a minimum size and a minimum period of time over which the borrower can
withdraw funds.
C.  A line of credit facility is a credit facility with a maximum size and a maximum period of time over which the borrower
can withdraw funds.
D.  A line of credit facility is a credit facility with a minimum size and a maximum period of time over which the borrower can
withdraw funds.
 
9. Which of the following statements is true?
A.  A commercial paper is an unsecured long-term debt instrument issued by corporations.
B.  A commercial paper is a secured long-term debt instrument issued by corporations.
C.  A commercial paper is a secured short-term debt instrument issued by corporations.
D.  A commercial paper is an unsecured short-term debt instrument issued by corporations.
 
10. The term disintermediation refers to the process in which firms access:
A.  money markets directly
B.  money markets via financial intermediaries
C.  capital markets directly
D.  capital markets via financial intermediaries
 
11. A credit line on which a borrower can both draw and repay many times over the life of the loan contract is called a:
A.  reviving loan
B.  revolving loan
C.  refilling loan
D.  A credit line does not exist.

12. The prime lending rate is the:

A.  risk premium periodically set by the RBA
B.  base lending rate periodically set by banks
C.  base lending rate periodically set by the RBA
D.  risk premium periodically set by banks
 
13. Which of the following statements is false?
A.  Default risk is the risk that the borrower is willing but unable to fulfil the terms promised under loan contract.
B.  Default risk is the risk that the borrower refinances the loan before maturity.
C.  Default risk is the risk that the borrower is able but unwilling to fulfil the terms promised under loan contract.
D.  Default risk is the risk that the borrower is unable and unwilling to fulfil the terms promised under loan contract.
 
14. Which of the following statements is true?
A.  Credit rationing means that the FI restricts the quantity of loans made available to an individual borrower.
B.  Credit rationing means that the FI restricts the type of loans made available to an individual borrower.
C.  Credit rationing means that the FI restricts the quality of loans made available to an individual borrower.
D.  Credit rationing means that the FI does not have sufficient funds available for lending and thus only grants loans to
selected borrowers.
 
15. ... are restrictions written into bond and loan contracts either limiting or encouraging the borrower's actions that affect the
probability of repayment.
 
A. Covenants
B. Implicit contracts
C. Credit rationings
D. Options

16. Which of the following statements is true?

A.  An example of a covenant is a restriction that limits those actions of the borrower that have an impact on the probability
of repayment.
B.  An example of a covenant is a restriction that encourages those actions of the borrower that have an impact on the
probability of repayment.
C.  A covenant is a restriction written into either bond or loan contracts.
D.  All of the listed options are correct.
 
17. Which of the following is the correct definition of leverage?
A.  Leverage is the ratio of equity to debt.
B.  Leverage is the ratio of assets to debt.
C.  Leverage is the ratio of debt to assets.
D.  Leverage is the ratio of debt to equity.
 
18. Which of the following statements is true?
A. A credit scoring model is a mathematical model that considers a borrower's credit rating to make loan decisions.
B. A credit scoring model is a model that relies on expert knowledge to make loan decisions.
C. A credit scoring model is a mathematical model that uses observed borrower characteristics to calculate a score
representing the applicant's probability of default or to sort borrowers into different default classes.
D. A credit scoring model is a mathematical model that uses neural networks to make loan decisions.

 19. Which of the following statements is true?

A.  Zero-coupon corporate bonds are bonds without any intervening cash flows between issue and maturity and thus these
bonds typically sell at a large discount from face value.
B.  Zero-coupon corporate bonds are bonds with semi-annual cash flows between issue and maturity and thus these bonds
typically sell at a large discount from face value.
C.  Zero-coupon corporate bonds are bonds without any intervening cash flows between issue and maturity and thus these
bonds typically sell at a small discount from face value.
D.  Zero-coupon corporate bonds are bonds with annual cash flows between issue and maturity and thus these bonds
typically sell at a large discount from face value.

 20. Which of the following statements is true?

A.  Arbitrage means the inability to make a profit without taking risk.
B.  Arbitrage means that an FI takes risks in order to make a profit.
C.  Arbitrage means that an FI does not take any risks and thus does not make a profit.
D.  Arbitrage means the ability to make a profit without taking risk.
 
21. Which of the following statements is true?
A.  Cumulative default probability is the probability that a borrower will default over a specified multi-year period.
B.  Cumulative default probability is the probability that a borrower will default in any given year.
C.  Marginal default probability is the probability that a cluster of borrowers will default over a specified multi-year period.
D.  None of the listed options are correct.
22. Which of the following statements is true?
A.  Marginal mortality rate is the historic default rate experience of a bond or loan.
B.  The mortality rate is the probability of a bond or loan defaulting over a specified multi-year period.
C.  Marginal mortality rate is the probability of a bond or loan defaulting in any given year of issue.
D.  Marginal mortality rate is the probability of a bond or loan defaulting over a specified multi-year period.
 
23. Which of the following statements is true?
A.  RAROC is the risk-adjusted return on capital.
B.  RAROC is calculated as the capital at risk divided by the loan's income.
C.  RAROC should always be below an FI's RAROC benchmark as otherwise the FI increases its default risk exposure.
D.  None of the listed options are correct.
 
24. Consider the following formula for calculating the contractually promised gross return on a loan k, per dollar lent: (1 + k) = 1 + [f +
(BR + m)]/ {1 – [b(1 – R)]}. Which of the following statements is true?
A.  The denominator is the promised gross cash inflow to the FI per dollar.
B.  The denominator reflects direct fees plus the loan interest rate consisting of both, the base lending rate and the credit
risk premium.
C.  The formula ignores present value aspects.
D.  The FI's net benefit from requiring compensating balances must consider the benefits of holding additional non-interest
bearing reserve requirements.
 
25. Consider the following scenario: an FI charges a 0.5% loan origination fee and imposes an 8% compensating balance
requirement to be held as non-interest-bearing demand deposits. It further sets aside reserves held at the central bank. The value of
these reserves is 10% of deposits. The base lending rate is 9% and the credit risk premium for a specific borrower is 3%. What is the
ROA on the loan?
A.  12.60%
B.  11.00%
C.  11.50%
D.  There is not enough information to solve the question.
26. Consider the following scenario: an FI charges a 0.5% loan origination fee and imposes a 10% compensating balance
requirement to be held as non-interest-bearing demand deposits. It further sets aside reserves held at the central bank. The value of
these reserves is 15% of deposits. What is the base lending rate if the credit risk premium is 3.055% and the ROA on the loan is
17%?
A.  11.5%
B.  13.945%
C.  12%
D.  20.055%
 
27. Which of the following statements is true?
A.  Borrower-specific factors are factors that affect all borrowers operating in the same industry.
B.  Market-specific factors are factors that are idiosyncratic factors arising from the market that affects single or a small
number of borrowers.
C.  Market-specific factors carry a higher weight compared to borrower-specific factors when deciding on whether to accept
or to reject a loan application.
D.  None of the listed options are correct.
 
28.  Assume that there are two factors influencing the past default behaviour of borrowers, these being the debt to equity ratio and
the sales to assets ratio. Based on past default (repayment) experience, the linear probability model is estimated as Zi = 0.3(D/Ei) +
0.15 (S/Ai). Assume that a prospective borrower has a D/E ratio of 0.9 and a sales to assets ratio of 2.5. What is the borrower's
probability of default?
 A. 0.885
B. 0.645
C. 0.45
D. 3.4

29. Which of the following statements in relation to Altman's discriminant function is true?

A.  The higher the Z-score the higher the probability of default.
B.  The loan size does not influence the result of the Altman Z-score model.
C.  The size of the borrower does not influence the result of the Altman Z-score model.
D.  The Altman Z-score model always produces an exact reject or accept decision.

30. Consider the following data of a prospective borrower.

What is this company's Z-score ?

A. 2.70
B. 2.80
C. 2.90
D. 3.00

31. Consider the following data of a prospective borrower.

What is this company's Z-score (round to two decimals)?

A. 3.78
B. 3.88
C. 3.98
D. 4.08

32. How would you interpret a Z-score of 2.25?

A. The Z-score lies within the 'safe' zone and thus a loan should be granted.
B. The Z-score lies within the 'high default' zone and thus a loan should be granted.
C. The Z-score lies within the 'zone of ignorance' and thus the borrower may or may not default.
D. The interpretation of the Z-score is always dependent on an FI manager's subjective opinion.

33. Assume the interest rate in the market for one-year zero-coupon government bonds is i = 8% and the rate for one-year zero-
coupon grade BBB bonds is k = 10.2%. What is the implied probability of repayment on the corporate bond (round to two decimals)?
A.  2.00%
B.  2.04%
C.  97.96%
D.  98.00%
34. Assume the interest rate in the market for one-year zero-coupon government bonds is i = 7.5% and the rate for one-year zero-
coupon grade BB bonds is k = 11.8%. What is the implied probability of default on the corporate bond (round to two decimals)?
A.  3.85%
B.  4.00%
C.  96.00%
D.  96.15%
 35. Consider the case of a simple one-period framework. If i = 12.30% and k = 13.87%, what is the risk premium on the corporate
lon (round to two decimals)?
A.  13.87% – 12.30% = 1.57%
B.  13.87% 12.30% = 0.0171 = 1.71%
C.  13.87% / 12.30% = 1.13%
D.  The risk premium equals k = 13.87%
 
36. Consider the case of a simple one-period framework. If i = 12.50%, k = 14.85%, p = 0.98, and g = 0.85 what is the required risk
premium (round to two decimals)?
A.  0.34%
B.  0.35%
C.  0.98%
D.  2.35%
 
37. Consider the case of ABC Company. The company's marginal probability of default in year 1 is 0.03 and 0.08 in year 2. What is
ABC Company's cumulative default probability (round to two decimals)?
A.  14.00%
B.  11.00%
C.  99.76%
D.  10.76%

38.  Assume that i1 = 11% and i2 = 12%, and that k1 = 14.50% and k2 = 16.50%. What is the expected probability of repayment on
the one-year corporate bonds in one year's time (round to two decimals)?
A. 86.99%
B. 81.47%
C. 86.50%
D. 95.34%
 
39. The current required yields on one- and two-year government bonds are i1 = 12% and i2 = 13%. What are the market's
expectations of the one-year forward rate, f1 (round to two decimals)?
 
A. 13.50%
B. 14.00%
C. 14.50%
D. 15.00%
 
40.  Assume that f1 = 13.50% and c1 = 17.40%. Which of the following statements is true?
 A. The expected default probability of repayment is 96.10%.
B. The expected probability of repayment is 3.32%.
C. The one-year rate expected on corporate securities one year into the future is 13.50%.
D. The current one-year rate on corporate securities is 17.40%.
 
41. Assume a $500 000 loan has a duration of 2.5 years. The current interest rate level is 10% and a sudden change in the credit
premium of 1% is expected. Further assume that the one-year income on the loan is $2500. What is the loan's RAROC (round to two
decimals)?
A.  10.00%
B.  11.00%
C.  22.00%
D.  50.00%

42. In the context of the KMV Credit Monitor Model, the market value of a risky loan made by a lender to a borrower can be
expressed as:
A.  F(r) = Be–i/r[(1/d)N(h1) + N(h2)]
B.  F(r) = Be–ir[(1/d)N(h1) + N(h2)]
C. F(r) = Be–ir[(1/d)– N(h1) + N(h2)]
D. F(r) = Be–ir[(1/d)N(h1) N(h2)]

43. Which of the following statements is true?

A.  Moody's KMV Credit Monitor model compares loans with the pay-off functions of swaps.
B.  Moody's KMV Credit Monitor model uses rating migrations data to calculate hypothetical loan values.
C.  Moody's KMV Credit Monitor model discriminates between two types of borrowers, that is, borrowers that are likely to
default and borrowers that are unlikely to default.
D.  None of the listed options are correct.

44.  Assume that B = $200 000, r = 1 year, i = 7%, d = 0.9, N(h1) = 0.174120 and N(h2) = 0.793323. Using Moody's KMV Credit
Monitor model, what is the current market value of the loan (round to two decimals)?
 A. $184 015.32
B. $186 478.64
C. $200 000.00
D. $214 000.00

45.  Assume that B = $200 000, r = 1 year, i = 7%, d = 0.9, N(h1) = 0.174120 and N(h2) = 0.793323. Using Moody's KMV Credit
Monitor model, what is the required risk premium on the loan (round to two decimal places)?
 A. 0.13%
B. 0.91%
C. 1.64%
D. 6.30%

46. Non-performing loans are loans:

A.  given out to corporations with low credit ratings
B.  that require re-evaluating of credit terms after every six months
C.  characterised by some type of default—from non-payment to delays in payment of interest and/or principal
D.  None of the listed options are correct.

47. Loan to value ratio is the:

A.  loan amount divided by the book value of the property to be mortgaged
B.  loan amount divided by the perceived value of the property to be mortgaged
C.  investment amount divided by the appraised value of the property to be mortgaged
D.  loan amount divided by the appraised value of the property to be mortgaged
 
48. The key factors entering into the credit decision include:
A.  borrower-specific factors that are idiosyncratic to the individual borrower
B.  market-specific factors that have an impact on all borrowers at the time of the credit decision
C.  global-economic factors that have an impact on all FIs at the time of credit decision
D.  borrower-specific factors that are idiosyncratic to the individual borrower and market-specific factors that have an
impact on all borrowers at the time of the credit decision
 
49. Credit scoring models include:
A.  linear probability models
B.  logit models
C.  linear discriminant analysis
D.  All of the listed options are correct.

 
50. The linear probability model uses:
A.  forecasted data, such as predicted future prices, as inputs into a model to explain repayment experience on old loans
B.  current indices, such as consumer price index, as inputs into a model to explain repayment experience on old loans
C.  past data, such as financial ratios, as inputs into a model to explain repayment experience on old loans
D.  None of the listed options are correct.

 51. Models of credit risk measurement include:

A.  term structure of credit risk approach.
B.  mortality rate approach
C.  RAROC and option models.
D.  All of the listed options are correct.
 
52. Compensating balance is a proportion of:
A.  a loan that a borrower is required to hold on deposit at a correspondent bank
B.  a loan that a borrower is required to hold on deposit in foreign reserves
C.  a loan that a borrower is required to hold on deposit at the lending institution
D.  the investment that a borrower is required to hold on deposit at the lending institution
 
53. Term structure of credit risk approach models are also known as:
A.  reduced-form models
B.  mortality rate models
C.  RAROC models
D.  structural models
 

73. Explain the major concept of Altman's linear discriminant model. What would you consider to be the major
disadvantages of this model? 

Discriminant models divide borrowers into high or low default risk classes contingent on their observed characteristics (Xj). Similar to
linear probability models, linear discriminant models use past data as inputs into a model to explain repayment experience on old loans.
The relative importance of the factors used in explaining past repayment performance then forecasts whether the loan falls into the high
or low default class.

In Altman's linear discriminant model, the indicator variable Z is the overall measure of the default risk classification of a borrower. This in
turn depends on the values of various financial ratios of the borrower (Xj) and the weighted importance of these ratios based on the past
observed experience of defaulting versus non-defaulting borrowers derived from a discriminant analysis model. According to Altman's
credit scoring model, a score of less than 1.81 would place the potential borrower into a high default risk category. Any score above 2.99
is regarded as a low default risk, while a score between 1.81 and 2.99 is in the 'zone of ignorance', where a borrower may or may not
default.

Several criticisms have been levied against linear discriminant models. First, the models identify only two extreme categories of risk:
default or no default. The real world considers several categories of default severity. Second, the relative weights of the variables may
change over time. Further, the actual variables to be included in the model may change over time. Third, these models ignore important,
hard-to-quantify factors that may play a crucial role in the default or no default decision. For example, the reputation of the borrower and
the nature of long-term borrower–lender relationships could be important borrower-specific characteristics, as could macroeconomic
factors, such as the phase of the business cycle. Fourth, no centralised database on defaulted business loans for proprietary and other
reasons exists. This constrains the ability of many FIs to use traditional credit scoring models (and quantitative models in general) for
larger business loans.

 74. Explain the concept of RAROC and the major role RAROC models play in credit risk analysis. 

The RAROC (risk-adjusted return on capital) model is a popular model used to evaluate (and price) credit risk based on market data.
The essential idea behind RAROC is that rather than evaluating the actual or contractually promised annual ROA on a loan—that is, net
interest and fees divided by the amount lent—the lending officer balances expected interest and fee income against the loan's expected
risk. Thus, rather than dividing annual loan income by assets lent, it is divided by some measure of asset (loan) risk, or what is often
called 'capital at risk', since (unexpected) loan losses have to be written off against an FI's capital:

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 (DR) is measured by finding the change in the spread in yields between Treasury Bonds and
corporate 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, DLN represents the change in loan value or the change in capital for the largest reasonable
adverse changes in yield spreads. The actual equation for DLN looks very similar to the duration equation.
A loan is approved only if RAROC is sufficiently high relative to a benchmark return on capital (ROE) for the FI, where ROE measures
the return shareholders require on their equity investment in the FI. The idea here is that a loan should be made only if the risk-adjusted
return on the loan adds to the FI's equity value as measured by the ROE required by the FI's shareholders. Alternatively, if the RAROC
on an existing loan falls below an FI's RAROC benchmark, the lending officer should seek to adjust the loan's terms to make it 'profitable'
again. Therefore, RAROC serves as both a credit risk measure and a loan pricing tool for the FI manager.

75. What are the major ideas behind KMV's Credit Monitor model? 

The KMV model uses an option pricing model (OPM) approach to extract the implied market value of assets and the asset volatility of a
given firm's assets. The KMV model uses the value of equity in a firm (from a shareholder's perspective) as equivalent to holding a call
option on the assets of the firm (with the amount of debt borrowed acting similar to the exercise price of the call option). From this
approach, and the link between the volatility of the market value of the firm's equity and that of its assets, it is possible to derive the asset
volatility (risk) of any given firm and the market value of the firm's assets. Using the implied value of the asset volatility and the market
value of assets, the likely distribution of possible asset values of the firm relative to its current debt obligations and the expected default
frequency (EDF) can be calculated over the next year. The EDF reflects the probability that the market value of the firm's assets will fall
below the promised repayments on its short-term debt liabilities in one year. If the value of a firm's assets falls below its debt liabilities, it
can be viewed as being economically insolvent.