Dr.

Le Anh Tuan

Selected Problems for Session 5 – Credit Risk

S5.1
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?

S5.2
As a senior loan officer at MC Bancorp, you have the following loan applications waiting for
review. The bank uses Altman’s Z score, default probabilities, mortality rates, and RAROC to
assess loan acceptability. The bank’s cost of equity (the RAROC benchmark) is 8 percent. The
bank’s loan policy states that the maximum probability of default for loans by type is as follows:

Which loans should be approved and which rejected?

1.
An AAA-rated, one-year C&I loan from a firm with a liquidity ratio of 2.15, a debt-to-asset ratio
of 45 percent, volatility in earnings of 0.13, and a profit margin of 12 percent. MC Bancorp uses a
linear probability model to evaluate AAA-rated loans as follows:
PD = −0.08X1 + 0.15X2 + 1.25X3 − 0.45X4 where
X1 = Liquidity ratio, X2 = Debt-to-asset ratio, X3 = Volatility in earnings, X4 = Profit margin
2.
An AA-rated, one-year C&I loan from a firm with the following financial statement information
(in millions of dollars):
 Dr. Le Anh Tuan

Also assume sales = $1,250 m, cost of goods sold = $930 m, and the market value of equity is
equal to 2.2 times the book value. MC Bancorp uses Altman’s Z score model to evaluate AA-
rated loans.
3.

An A-rated corporate loan with a maturity of three years. A-rated corporate loans are evaluated
using the mortality rate approach. A schedule of historical defaults (annual and cumulative)
experienced by the bank on its A-rated corporate loans is as follows:

4.

A $2 million, five-year loan to a BBB-rated corporation in the computer parts industry. MC Ban-
corp charges a servicing fee of 75 basis points. The duration on the loan is 4.5 years. The cost of
funds for the bank (the RAROC benchmark) is 8 percent. Based on four years of historical data,
the bank has estimated the maximum change in the risk premium on the computer parts industry
to be approximately 5.5 percent. The current market rate for loans in this industry is 10 percent.

S5.3

Suppose that an FI holds two loans with the following characteristics:

Loan i X i R i σi σi
2
.
1 0.55 8% 8.55% 73.1025% ρ = 0.24
12

2 0.45 10 9.15 83.7225 σ = 18.7758

12

Calculate the return and risk of the portfolio.

S5.4
As a credit officer, you may want some assurance that your loan will grow and net you a profit.
An expected return and a standard deviation are two statistical measures that FI can use to analyze
their portfolios. The expected return is the anticipated amount of returns that a loan may generate,
whereas the standard deviation of a loan measures the amount that the returns deviate from its
 Dr. Le Anh Tuan

mean. In the proposal, there are 3 loans that will be evaluated. The below information shows the
probabilities of occurrence and returns for each loan in different status of economy, respectively.
Note that all calculations are rounded to one-decimal digit.
State of Probability of Return of loan Return of loan Return of loan
Economy Occurrence A B C
Depression 0.25 0.08 0.00 0.08
Recession 0.10 0.15 0.06 0.11
Normal 0.35 0.20 0.12 0.15
Boom 0.30 0.30 0.22 0.37

a. Calculate the expected return and risk of each loan.

b. Based on the results in (a), how would you rank the three loans?
c. Construct a loan portfolio with the weights 4:6 for loans A and C, respectively. Find the
expected return and risk of the portfolio. Assume the correlation coefficient between loans
A and C equal -0.8.
d. Comment on the return and risk of this portfolio.
e. Assume the correlation coefficient between loans A and C is 0.7. Compare the benefit of
diversification in this situation and the result in part (c).