1.What types of variables normally are used in a CRA Z-score model? Define the following ratios and explain how each is interpreted in assessing the probability of rescheduling.
2.What three country risk assessment models are available to investors? How is each model compiled?
3.What is the difference between debt rescheduling and debt repudiation?
4.What risks are incurred in making loans to borrowers based in foreign countries? Explain.
5.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.
6.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?
7.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 DLN in the RAROC equation?
8.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?
9.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.
Spot 1 Year Spot 2 Year Spot 3 Year
The notation used for implied forward rated on treasries is f1=forward rate from period 1 to period 2 and on corporate bonds is c1=forward rate from period 1 to period 2.
10.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?