Chapter 11

Credit Risk: Individual Loan Risk

Chapter Outline

Introduction

Credit Quality Problems

Types of Loans
Commercial and Industrial Loans
Real Estate Loans
Individual (Consumer) Loans
Other Loans

The Return on a Loan

The Contractually Promised Return on a Loan
The Expected Return on a Loan

Retail versus Wholesale Credit Decisions

Retail
Wholesale

Measurement of Credit Risk

Default Risk Models

Qualitative Models
Credit Scoring Models

Newer Models of Credit Risk Measurement and Pricing

Term Structure Derivation of Credit Risk
Mortality Rate Derivation of Credit Risk
RAROC Models
Option Models of Default Risk

Summary

Appendix 11A: CreditMetrics

Rating Migration
Valuation
Calculation of VAR
Capital Requirements

Appendix 11B: Credit Risk+

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 Solutions for End-of-Chapter Questions and Problems: Chapter Eleven

1. Why is credit risk analysis an important component of bank risk management? What recent
activities by FIs have made the task of credit risk assessment more difficult for both bank
managers and regulators?

Credit risk management is important for bank managers because it determines several features of
a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more
analysis before loans are approved. If credit risk analysis is inadequate, default rates could be
higher and push a bank into insolvency, especially if the markets are competitive and the margins
are low.

Credit risk management has become more complicated over time because of the increase in off-
balance-sheet activities that create implicit contracts and obligations between prospective lenders
and buyers. Credit risks of some off-balance-sheet products such as loan commitments, options,
and interest rate swaps, are difficult to assess because the contingent payoffs are not
deterministic, making the pricing of these products complicated.

2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a
fixed-rate loan? Why would bankers prefer to charge floating rates, especially for longer-
maturity loans?

A secured loan is backed by some of the collateral that is pledged to the lender in the event of
default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
In a fixed-rate loan, the lender of the loan bears the risk of interest rate changes; if interest rates
rise, the opportunity cost of lending is higher. If interest rates fall, the lender benefits. Since it is
harder to predict longer-term rates, FIs prefer to charge floating rates for longer-term bonds and
pass the risks on to the borrower.

3. How does a spot loan differ from a loan commitment? What are the advantages and
disadvantages of borrowing through a loan commitment?

A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan
commitment allows a borrower the option to take down the loan any time during a fixed period
at a predetermined rate. This can be advantageous during periods of rising rates in that the
borrower can borrow as needed at a predetermined rate. If the rates decline, the borrower can
borrow from other sources. The disadvantage is the cost: an up-front fee is required in addition to
a back-end fee for the unused portion of the commitment.

4. Why is commercial lending declining in importance in the U.S.? What effect does the
decline have on overall commercial lending activities?

Commercial bank lending has been declining in importance because of disintermediation, a

process in which customers are able to access financial markets directly such as in issuing
commercial paper. The total amount of commercial paper outstanding in the U.S. has grown
dramatically over the last decade. Historically, only the most creditworthy borrowers had access

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the commercial paper market, but more middle-market firms and financial institutions now have
access to this market. As a consequence of this growth, the pool of borrowers available to
bankers has become smaller and riskier. This makes the credit assessment and monitoring of
loans more difficult.

5. 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 the interest rate
cycle? When would the ratio be highest?

Residential mortgages contracts differ in size, the ratio of the loan amount to the value of the
property, the maturity of the loan, the rate of interest of the loan, and whether the interest rate is
fixed or adjustable. In addition, mortgage agreements differ in the amount of fees, commissions,
discounts, and points that are paid by the borrower.

The ratio of adjustable rate mortgages to fixed-rate mortgages is lowest when interest rates are
low because borrowers prefer to lock in the low market rates for long periods of time. When
rates are high, the adjustable rate mortgages allow borrowers the potential to realize relief from
high interest rates in the future when rates decline.

6. What are the two major classes of consumer loans at U.S. banks? How do revolving loans
differ from automobile and other consumer installment loans?

Consumer loans can be classified as either nonrevolving or revolving loans. Automobile loans
and fixed-term personal loans usually have a maturity date at which time the loan is expected to
have a zero balance, and thus they are considered to be nonrevolving loans. Revolving loans
usually involve credit card debt, or similar lines of credit, and as a result the balance will rise and
fall as borrowers make payments and utilize the accounts. These accounts typically have
maturities of 1 to 3 years, but the accounts normally are renewed if the payment history is
satisfactory. Many banks often recognize high rates of return on these loans, even though in
recent years, banks have faced chargeoff rates in the range of four to eight percent.

7. How does the credit card transaction process assist in the credit monitoring function of
financial institutions? Which major parties receive a fee in the typical credit card
transaction? Do the services provided warrant the payment of these associated fees?

Credit card transactions typically must be authorized by the cardholder’s bank. Thus verification
of satisfactory credit quality occurs with each transaction. During the transaction process, fixed
fees are charged to the merchant, the merchant’s bank, and the card issuer. The fees cover the
data processing and technology services necessary to ensure that the revolving credit transaction
process is accomplished.

8. 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
credit-granting depository FI. Thus the funds are not available for use by the borrower. As the

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amount of compensating balance for a given loan size increases, the effective return on the loan
increases for the lending institution.

9. 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?

The true cost is the loan rate ÷ (1 – compensating balance rate) = 9% ÷ (1.0 – 0.1) = 10 percent.
For compensating balance rates of 15 percent and 20 percent, the true cost of the loan would be
10.59 percent and 11.25 percent respectively. Note that as the compensating balance rate
increases by a constant amount, the true cost of the loan increases at an increasing rate.

10. 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?

The simple promised interest return on the loan is BR + m = 0.09 + 0.025 = 0.115 or 11.5
percent.

b. What is the contractually promised gross return on the loan per dollar lent?

σf + (B R + m) 0.0
025 + 9 +
( 0.0 0.025 ) 0.117
5
k =1+ −1=1+ −1=1+ −1=1
2 .9
7 p
ercen
t
1− [ b (1 −RR )] 1− [ 0.1(1 − 0.06 )] 0.9
06

c. Which of the fee items has the greatest impact on the gross return?

The compensating balance has the strongest effect on the gross return on the loan. Without
the compensating balance, the gross return would equal 11.75 percent, a reduction of 1.22
percent. Without the origination fee, the gross return would be 12.69 percent, a reduction
of only 0.28 percent. Eliminating the reserve requirement would cause the gross return to
increase to 13.06 percent, an increase of 0.09 percent.

11. 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.

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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.

12. 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?

An increase in risk premiums indicates a riskier pool of clients who are more likely to default by
taking on riskier projects. This reduces the repayment probability and lowers the expected return
to the lender. In both cases the lender often is able to charge fees that increase the return on the
loan. However, in both cases also, the fees may become sufficiently high as to increase the risk
of nonpayment of default on the loan.

13. What are covenants in a loan agreement? What are the objectives of covenants? How can
these covenants be negative? Affirmative?

Covenants are restrictions that are written into loan or bond contracts that affect the actions of
the borrower. Negative covenants in effect restrict actions, that is, they are “thou shall not...”
conditions. Common examples include the nonincrease of dividend payments without
permission of the borrower, or the maintenance of net working capital above some minimum
level. Positive covenants encourage actions such as the submission of quarterly financial
statements. In effect both types of covenants are designed and implemented to assist the lending
firm in the monitoring and control of credit risk.

14. 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.

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 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.

a. Which of these factors is more likely to affect adversely small businesses rather than
large businesses in the credit assessment process by lenders?

Because reputation involves a history of performance over an extended time period, small
businesses that are fairly young in operating time may suffer.

b. How does the existence of a high debt ratio typically affect the risk of the borrower? Is
it possible that high leverage may reduce the risk of bankruptcy (or the risk of financial
distress)? Explain.

Increasing amounts of debt increase the interest charges that must be paid by the borrower,
and thus decrease the amount of cash flows available to repay the debt principal. Cases
have been made that high debt levels require the firm to be very efficient in its managerial
decision making, thus reducing the probability of bankruptcy.

c. Why is the volatility of the earnings stream of a borrower important to a lender?

A highly volatile earnings stream increases the probability that the borrower cannot meet
the fixed interest and principal payments for any given capital structure.

15. Why is the degree of collateral as specified in the loan agreement of importance to the
lender? If the book value of the collateral is greater than or equal to the amount of the loan,
is the credit risk of the lender fully covered? Why, or why not?

Collateral provides the lender with some assets that can be used against the amount of the loan in
the case of default. However, collateral has value only to the extent of its market value, and thus
a loan fully collateralized at book value may not be fully collateralized at market value. Further,
errors in the recording of collateralized positions may limit or severely reduce the protected
positions of a lender.

16. Why are FIs consistently interested in the expected level of economic activity in the
markets in which they operate? Why is monetary policy of the Federal Reserve System
important to FIs?

During recessions firms in certain industries are much more likely to suffer financial distress
because of the slowdown in economic activity. Specifically, the consumer durables industries
are particularly hard hit because of cutbacks in spending by consumers. Fed monetary actions
that increase interest rates cause FIs to sustain a higher cost of funds and cause borrowers to
increase the risk of investments. The higher cost of funds to the FI can be passed along to the
borrower, but the increased risk in the investment portfolio necessary to generate returns to cover
the higher funding cost to the borrower may lead to increased default risk realization. Thus
actions by the Fed often are signals of future economic activity.

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17. What are the purposes of credit scoring models? How could these models possibly assist
an FI manager to better administer credit?

Credit scoring models are used to calculate the probability of default or to sort borrowers into
different default risk classes. The primary benefit is to improve the accuracy of predicting
borrower’s performance without using additional resources. This benefit results in fewer
defaults and chargeoffs to the FI.

The models use data on observed economic and financial borrower characteristics to assist an FI
manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the
relative degree of importance of these factors, (c) improving the pricing of default risk, (d)
screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to
protect against future loan losses.

18. Suppose the estimated linear probability model is PD = 0.3X1 + 0.2X2 - .05X3 + error,
where X1 = 0.75 is the borrower's debt/equity ratio; X2 = 0.10 is the volatility of borrower
earnings; and X3 = 0.10 is the borrower’s profit ratio.

a. What is the projected probability of default for the borrower?

PD = 0.3(.75) + 0.2(.25) - 0.05(.10) = 0.27

b. What is the projected probability of repayment if the debt/equity ratio is 2.5?

PD = 0.3(2.5) + 0.2(.25) - 0.05(.10) = 0.795

The expected probability of repayment is 1 - 0.795 = 0.205.

c. What is a major weakness of the linear probability model?

A major weakness of this model is that the estimated probabilities can be below 0 or above
1.0, an occurrence that does not make economic or statistical sense.

19. Describe how a linear discriminant analysis model works. Identify and discuss the
criticisms that have been made regarding the use of this type of model to make credit risk
evaluations.

Linear discriminant models divide borrowers into high or low default classes contingent on their
observed characteristics. The overall measure of default risk classification (Z) depends on the
values of various financial ratios and the weighted importance of these ratios based on the past or
observed experience. These weights are derived from a discriminant analysis model.

Several criticisms have been levied against these types of 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, hard to
define, but potentially important, qualitative variables are omitted from the analysis. Fourth, the

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real-world database of defaulted loans is very incomplete. Finally, the model is very sensitive to
changes in variables. A change in sales of 40 percent may cause the model to provide different
accept/reject decisions, but a decrease in sales in the real world normally is not seen as hard
evidence that credit should be denied or withdrawn from an otherwise successful company.

20. MNO, Inc., a publicly traded manufacturing firm in the United States, has provided the
following financial information in its application for a loan.

Assets Liabilities and Equity

Cash $ 20 Accounts Payable $ 30
Accounts Receivables $ 90 Notes Payable $ 90
Inventory $ 90 Accruals $ 30
Long Term Debt $150
Plant and equipment $500 Equity $400
Total Assets $700 Total Liabilities & Equity $700

Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40,
net income = $44, the dividend payout ratio is 50 percent, and the market value of equity is
equal to the book value.

a. What is the Altman discriminant function value for MNO, Inc.? Recall that:

Net working capital = Current assets minus current liabilities.

Current assets = Cash + accounts receivable + inventories.
Current liabilities = Accounts payable + accruals + notes payable.
EBIT = Revenues - Cost of goods sold - depreciation.
Taxes = (EBIT - Interest)(tax rate).
Net income = EBIT - interest - taxes.
Retained earnings = Net income (1 - dividend payout ratio)

Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Assume prior retained earnings are zero.

X1 = (200 -30 -30 -90)/ 700 = .0714 X1 = Working capital/total assets (TA)
X2 = 22 / 700 = .0314 X2 = Retained earnings/TA
X3 = 140 / 700 = .20 X3 = EBIT/TA
X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term debt
X5 = 500 / 700 = .7143 X5 = Sales/TA
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104
= .0857 + .044 + .66 + 1.6 + .7143 = 3.104

b. Should you approve MNO, Inc.'s application to your bank for a $500 capital expansion
loan?

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 Since the Z-score of 3.104 is greater than 1.81, ABC Inc.’s application for a capital
expansion loan should be approved.

c. If sales for MNO were $300, the market value of equity was only half of book value,
and the cost of goods sold and interest 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?

ABC’s net income would be -$100 without taking into account text credits. Note, that
ABC's tax liability is -$56,000. If we assume that ABC uses this tax credit against other
tax liabilities, then:

X1 = (200 - 30 - 30 - 90) / 700 = .0714

X2 = -44 / 700 = -0.0629
X3 = -60 / 700 = -0.0857
X4 = 200 / 150 = 1.3333
X5 = 300 / 700 = 0.4286

Since ABC's Z-score falls to $.9434 < 1.81, credit should be denied.

d. Would the discriminant function change for firms in different industries? Would the
function be different for retail lending in different geographic sections of the country?
What are the implications for the use of these types of models by FIs?

The discriminant function models are very sensitive to the weights for the different
variables. Since different industries have different operating characteristics, a reasonable
answer would be affirmative with the condition that there is no reason that the functions
could not be similar for different industries. In the retail market, the demographics of the
market play a big role in the value of the weights. For example, credit card companies
often evaluate different models for different areas of the country. Because of the sensitivity
of the models, extreme care should be taken in the process of selecting the correct sample
to validate the model for use.

21. Consider the coefficients of Altman’s Z-score. Can you tell by the size of the coefficients
which ratio appears most important in assessing the creditworthiness of a loan applicant?
Explain.

Although X3, or EBIT/total assets has the highest coefficient (3.3), it is not necessarily the most
important variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be
quite small. For some firms, particularly those in the retail business, the asset turnover ratio, X5
may be quite large and the product of the X5 coefficient (1.0) and X5 may be substantially larger
than the corresponding number for X3. Generally, the factor that adds most to the Z score varies
from firm to firm and industry to industry.

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22. If the rate of one-year T-Bills currently is 6 percent, what is the repayment probability for
each of the following two securities? Assume that if the loan is defaulted, no payments are
expected. What is the market-determined risk premium for the corresponding probability
of default for each security?

a. One-year AA rated bond yielding 9.5 percent?

Probability of repayment = p = (1 + I)/(1 + k)
For an AA-rated bond = (1 + .06)/ (1 + .095) = 0.968, or 96.8 percent

The market determined risk premium is 0.095 – 0.060 = 0.035 or 3.5 percent

b. One-year BB rated bond yielding 13.5 percent?

Probability of repayment = p = (1 + I)/(1 + k)

For BB-rated bond = (1 + .06)/(1 + .135) = 93.39 percent

The market determined risk premium is 0.135 – 0.060 = 0.075 or 7.5 percent

23. 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, it expects to recover 50 percent of its money
through the sale of its collateral. What is the expected return on this loan?

E(r) = p(1 + k) + (1 - p)(1 + k)(α ) where α is the percentage generated when the loan is
defaulted. E(r) = .95(1 + .10) + .05(1 + .10)(.50) = 1.0450 + .0275 = 1.0725 - 1.0 = 7.25%

24. Assume a one-year T-Bill is currently yielding 5.5 percent, and a AAA-rated discount bond
with similar maturity is yielding 8.5 percent.

a. If the expected recovery from collateral in the event of default is 50 percent of principal
and interest, what is the probability of repayment of the AAA-rated bond? What is the
probability of default?

p(1 + k) + γ (1 - p)(1 + k) = 1+I. Solve for the probability of repayment (p):

1 +i
−γ 1.055 −0.5
1 +k
p= =1.085 =0.9447 or 94 .47 percent
1 −γ 1 −0.5

Therefore the probability of default is 1.0 - .9447 = 0.0553 or 5.53 percent.

b. What is the probability of repayment of the AAA-rated bond if the expected recovery
from collateral in the case of default is 94.47 percent of principal and interest? What is
the probability of default?

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 1 +i
−γ 1.055 −0.9447
1 +k
p= =1.085 =0.5000 or 50 .00 percent
1 −γ 1 −0.9447

Therefore the probability of default is 1.0 – 0.5000 = 0.5000 or 50.00 percent.

c. What is the relationship between the probability of default and the proportion of
principal and interest that may be recovered in the case of default on the loan?

The proportion of the loan’s principal and interest that is collectible on default is a perfect
substitute for the probability of repayment should such defaults occur.

25. What is meant by the phrase marginal default probability? How does this term differ from
cumulative default probability? How are the two terms related?

Marginal default probability is the probability of default in the given time period, whereas
cumulative default probability is the probability of default across several time periods. For
example, the cumulative default probability across two time periods is given below, where (p) is
the probability of nondefault in a given time period.

CP2 = 1 – (p1) (p2)

26. Calculate the term structure of default probabilities over three years using the following
spot rates from the Treasury and corporate bond (pure discount) yield curves. Be sure to
calculate both the annual marginal and the cumulative default probabilities.

Spot Spot Spot

1 year 2 year 3 year
Treasury Bonds 5.0% 6.1% 7.0%
BBB rated Bonds 7.0% 8.2% 9.3%

The notation used for implied forward rates is f12 = forward rate from period 1 to period 2.

Treasury Securities BBB Graded Debt

(1.061)2 = (1.05)(1 + f12 ) (1.082)2 = (1.07)(1 + f12 )
f12 = 7.21% f12 = 9.41%

(1.07)3 = (1.061)2(1 + f23 ) (1.093)3 = (1.082)2(1 + f23 )

f23 = 8.82% f23 = 11.53%

Using the implied forward rates, estimate the annual marginal probability of repayment:

p01(1.07) = 1.05 => p1 = 98.13 percent

p12(1.0941) = 1.0721 => p2 = 97.99 percent
p23 (1.1153) = 1.0882 => p3 = 97.57 percent

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 Using marginal probabilities, estimate the cumulative probability of default:

cp02 = 1 - (p1 )(p2 )

= 1 - (.9813)(.9799) = 3.84 percent
cp03 = 1 - (p1 )(p2 )(p3 )
= 1 - (.9813)(.9799)(.9757) = 6.18 percent

27. The bond equivalent yields for U.S. Treasury and A-rated corporate bonds with maturities
of 93 and 175 days are given below:

Bond Maturities 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.

. The forward rate, f, for the period 93 days to 175 days, or 82 days, for the Treasury is:

(1 + 0.0811)175/365 = (1 + 0.0807)93/365 (1 + f )82/365 ⇒ f = 8.16 percent

The forward rate, f, for the corporate bond for the 82-day period is:

(1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + f )82/365 ⇒ f = 8.933%

b. What is the implied probability of default on A-rated bonds over the next 93 days?
Over 175 days?

The probability of repayment of the 93-day A-rated bond is:

p(1 + 0.0842)93/365 = (1 + 0.0807)93/365 ⇒ p = 99.92 percent
Therefore, the probability of default is (1 - p) = (1 - .9992) = 0.0008 or 0.08 percent.

The probability of repayment of the 175-day A-rated bond is:

p(1 + 0.0866)175/365 = (1 +0.0811)175/365 ⇒ p = 99.76 percent
Therefore, the probability of default is (1 - p) = (1 - .9976) = 0.0024 or 0.24 percent.

c. What is the implied default probability on an 82-day A-rated bond to be issued in 93

days?

The probability of repayment of the A-rated bond for the period 93 days to 175 days, p, is:
p (1.08933)82/365 = (1 + 0.0816)82/365 ⇒ p = .9984, or 99.84 percent
Therefore, the probability of default is (1 - p) or 0.0016 or 0.16 percent.

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28. What is the mortality rate of a bond or loan? What are some of the problems with using a
mortality rate approach to determine the probability of default of a given bond issue?

Mortality rates reflect the historic default risk experience of a bond or a loan. One major
problem is that the approach looks backward rather than forward in determining probabilities of
default. Further, the estimates are sensitive to the time period of the analysis, the number of
bond issues, and the sizes of the issues.

29. The following is a schedule of historical defaults (yearly and cumulative) experienced by
an FI manager on a portfolio of commercial and mortgage loans.

Years after Issuance

Loan Type 1 Year 2 Years 3 Years 4 Years 5 Years
Commercial:
Annual default 0.00% ______ 0.50% ______ 0.30%
Cumulative default ______ 0.10% ______ 0.80% ______
Mortgage:
Annual default 0.10% 0.25% 0.60% ______ 0.80%
Cumulative default ______ ______ ______ 1.64% ______

a. Complete the blank spaces in the table.

Commercial: Annual default 0.00%, 0.10%, 0.50%, 0.20%, and 0.30%

Cumulative default: 0.00%, 0.10%, 0.60%, 0.80%, and 1.10%
Mortgage: Yearly default 0.10%, 0.25%, 0.60%, 0.70%, and 0.80%
Cumulative default 0.10%, 0.35%, 0.95%, 1.64%, and 2.43%

Note: The annual survival rate is pt = 1 – annual default rate, and the cumulative default
rate for n = 4 of mortgages is 1 – (p1* p2* p3* p4) = 1 – (0.999*0.9975*0.9940*0.9930).

b. What are the probabilities that each type of loan will not be in default after 5 years?

The cumulative survival rate is = (1-mmr1)*(1-mmr2)*(1-mmr3)*(1-mmr4)*(1-mmr5)

where mmr = marginal mortality rate

Commercial loan = (1-0.)*(1-0.001)*(1-0.005)*(1-0.002)*(1-0.003) = 0.989 or 98.9%.

Mortgage loan = (1-0.001)*(1-0.0025)*(1-0.006)*(1-0.007)*(1-0.008) = 0.9757 or 97.57%.

c. What is the measured difference between the cumulative default (mortality) rates for
commercial and mortgage loans after four years?

Looking at the table, the cumulative rates of default in year 4 are 0.80% and 1.64%,
respectively, for the commercial and mortgage loans. Another way of estimation is:

Cumulative mortality rate (CMR) = 1- (1 - mmr1)(1 - mmr2)(1 - mmr3)(1 - mmr4)

For commercial loan = 1- (1 - 0.0010)(1 - 0.0010)(1 - 0.0020)(1 - 0.0050)

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 = 1- .9920 = 0.0080 or 0.80 percent.

For mortgage loan = 1- (1 - 0.0010)(1 - 0.0025)(1 - 0.0060)(1 - 0.0070)

= 1- .98359 = 0.01641 or 1.641 percent.
The difference in cumulative default rates is 1.641 - .80 = .8410 percent.

30. The Table below shows the dollar amounts of outstanding bonds and corresponding default
amounts for every year over the past five years. Note that the default figures are in millions
while those outstanding are in billions. The outstanding figures reflect default amounts and
bond redemptions.
Years after Issuance
Loan Type 1 Year 2 Years 3 Years 4 Years 5 Years
A-rated: Annual default (millions) 0 0 0 $1 $2
Outstanding (billions) $100 $95 $93 $91 $88

B-rated: Annual default (millions) 0 $1 $2 $3 $4

Outstanding (billions) $100 $94 $92 $89 $85

C-rated: Annual default (millions) $1 $3 $5 $5 $6

Outstanding (billions) $100 $97 $90 $85 $79

a. What are the annual and cumulative default rates of the above bonds?
A-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 0 100,000 0.000000 1.000000 0.000000 0.0000%
2 0 95,000 0.000000 1.000000 0.000000 0.0000%
3 0 93,000 0.000000 1.000000 0.000000 0.0000%
4 1 91,000 0.000011 0.999989 0.000011 0.0011%
5 2 88,000 0.000023 0.999977 0.000034 0.0034%
Where cumulative default for nth year = 1 - product of survival rates to that year.

B-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 0 100,000 0.000000 1.000000 0.000000 0.0000%
2 1 94,000 0.000011 0.999989 0.000011 0.0011%
3 2 92,000 0.000022 0.999978 0.000032 0.0032%
4 3 89,000 0.000034 0.999966 0.000066 0.0066%
5 4 85,000 0.000047 0.999953 0.000113 0.0113%

C-rated Bonds
Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate

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 1 1 100,000 0.000010 0.999990 0.000010 0.0010%
2 3 97,000 0.000031 0.999969 0.000041 0.0041%
3 5 90,000 0.000056 0.999944 0.000096 0.0096%
4 5 85,000 0.000059 0.999941 0.000155 0.0155%
5 6 79,000 0.000076 0.999924 0.000231 0.0231%
Years after Issuance
Bond Type 1 Year 2 Years 3 Years 4 Years 5 Years
A-rated: Yearly default 0% 0% 0% 0.0011% 0.0023%
Cumulative default 0% 0% 0% 0.0011% 0.0034%

B-rated: Yearly default 0% 0.0011% 0.0022% 0.0034% 0.0047%

Cumulative default 0% 0.0011% 0.0032% 0.0066% 0.0113%

C-rated: Yearly default 0.0010% 0.0031% 0.0056% 0.0059% 0.0076%

Cumulative default 0.0010% 0.0041% 0.0096% 0.0155% 0.0231%

Note: These percentage values seem very small. More reasonable values can be obtained
by increasing the default dollar values by a factor of ten, or by decreasing the outstanding
balance values by a factor of 0.10. Either case will give the same answers that are shown
below. While the percentage numbers seem somewhat more reasonable, the true values of
the problem are (a) that default rates are higher on lower rated assets, and (b) that the
cumulative default rate involves more than the sum of the annual default rates.

C-rated Bonds Test with 10x default.

Millions Millions Annual Survival = Cumulative % Cumulative
Year Default Balance Default 1 - An. Def. Default Rate Default Rate
1 10 100,000 0.000100 0.999900 0.000100 0.0100%
2 30 97,000 0.000309 0.999691 0.000409 0.0409%
3 50 90,000 0.000556 0.999444 0.000965 0.0965%
4 50 85,000 0.000588 0.999412 0.001552 0.1552%
5 60 79,000 0.000759 0.999241 0.002311 0.2311%
More meaningful to use 0.10x balance, will get same result.

31. 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. The RAROC model uses the duration model formulation 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 of 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

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changes in yield spreads. The actual equation for ∆ LN looks very similar to the duration
equation.

Net Income ∆R
RAROC = where ∆LN =−D
LN
x LN x where R is the change in yield spread .
Risk ( or ∆LN ) 1 +R

32. 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 and a
duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10
percent. Assume 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?

RAROC = Fees and interest earned on loan/ Loan or capital risk

Loan risk, or ∆ LN = -DLN*LN*(∆ R/(1 + R) = = -7.5 * $5m * (.042/1.12) = -

$1,406,250
Expected interest = 0.12 x $5,000,000 = $600,000
Servicing fees = 0.0050 x $5,000,000 = $25,000
Less cost of funds = 0.10 x $5,000,000 = -$500,000
Net interest and fee income = $125,000

RAROC = $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of
funds to the bank, the bank should not make the loan.

b. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:

$125,000/∆ LN = 0.10 ⇒ ∆ LN = 125,000 / 0.10 = $1,250,000
⇒ -DLN * LN * (∆ R/(1 + R)) = 1,250,000

DLN = 1,250,000/(5,000,000 * (0.042/1.12)) = 6.67 years.

Thus, this loan can be made if the duration is reduced to 6.67 years from 7.5 years. The
duration can be reduced.

c. Assuming that duration cannot be changed, how much additional interest and fee
income would be necessary to make the loan acceptable?
Necessary RAROC = Income/Risk ⇒ Income = RAROC * Risk
= $1,406,250 *0.10 = $140,625
Therefore, additional income = $140,625 - $125,000 = $15,625.

d. Given the proposed income stream and the negotiated duration, what adjustment in the
risk premium would be necessary to make the loan acceptable?

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 $125,000/0.10 = $1,250,000 ⇒ -$1,250,000 = -7.5*$5,000,000*(∆ R/1.12)
Thus ∆ R = 1.12(-$1,250,000)/(-7.5*$5,000,000) = 0.0373

33. 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 6 percent, and the standard deviation of the rate
of change in the underlying assets of the borrower is 10 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.

The following need to be estimated first: d, h1 and h2 .

d = Be-rt /A = $200,000e-.06(2) /300,000 = .5913 or 59.13 percent.

h1 = -[0.5*(.10)2 *2 - ln(.5913)]/(.10)21/2 = -3.7863
h2 = -[0.5*(.10)2 *2 + ln(.5913)]/(.10)21/2 = 3.6449

Current market value of loan = l(t) = Be-rt [N(h1)1/d + N(h2)]

= $177,384.09[1.6912 * N(-3.7863) + N(3.6449)]
= $177,384.09[1.6912 * 0.0001 + 0.9999] = $177,396.35

The risk premium k – I = (-1/t) ln[N(h2) + (1/d)N(h1)]

= (-½)ln[0.9999 + 1.6912*0.0001] = 0.00035

34. A firm has assets of $200,000 and total debts of $175,000. Using an option pricing model,
the implied volatility of the firm’s assets is estimated at $10,730. Under the KMV method,
what is the expected default frequency (assuming a normal distribution for assets)?

The firm will be in technical bankruptcy if the value of the assets fall’s below $175,000. If σ =
$10,730, then it takes 25,000/10,730 = 2.33 standard deviations for the assets to fall below this
value. Under the assumption that the market value of the assets are normally distributed, then
2.33 represents a 1 percent probability that the firm will become bankrupt.

35. Carman County Bank (CCB) has outstanding a $5,000,000 face value, adjustable rate loan
to a company that has a leverage ratio of 80 percent. The current risk free rate is 6 percent,
and the time to maturity on the loan is exactly ½ year. The asset risk of the borrower, as
measured by the standard deviation of the rate of change in the value of the underlying
assets, is 12 percent. The normal density function values are given below:

h N(h) h N(h)
-2.55 0.0054 2.50 0.9938
-2.60 0.0047 2.55 0.9946
-2.65 0.0040 2.60 0.9953

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 -2.70 0.0035 2.65 0.9960
-2.75 0.0030 2.70 0.9965

a. Use the Merton option valuation model to determine the market value of the loan.

The following need to be estimated first: d, h1 and h2 .

h1 = -[0.5*(0.12)2*0.5 - ln(0.8)]/(0.12)√0.5 = -0.226744/0.084853 = -2.672198
h2 = -[0.5*(0.12)2*0.5 + ln(0.8)]/(0.12)√0.5 = 0.219544/0.084853 = 2.587346

Current market value of loan = l(t) = Be-rt [N(h1)1/d + N(h2)]

= $4,852,227.67[1.25*N(-2.672198) + N(2.587346)]
= $4,852,227.67 [1.25*0.003778 + 0.995123]
= $4,851,478.00

b. What should be the interest rate for the last six months of the loan?

The risk premium k – I = (-1/t) ln[N(h2) + (1/d)N(h1)]

= (-1/0.5)ln[0.995123 + 1.25*0.003778] = 0.000308

The loan rate = risk-free rate plus risk premium = 0.06 + 0.000308 = 0.060308 or 6.0308%.

The questions and problems that follow refer to Appendixes 11A and 11B. Refer to the example
information in Appendix 11A.

36. From Table 11A-1, what is the probability of a loan upgrade? A loan downgrade?

The probability of an upgrade is 5.95% + 0.33% + 0.02% = 6.30%. The probability of a

downgrade is 5.30% + 1.17% + 0.12% = 5.59%.

a. What is the impact of a rating upgrade or downgrade?

The effect of a rating upgrade or downgrade will be reflected on the credit-risk spreads or
premiums on loans, and thus on the implied market value of the loan. A downgrade should
cause this credit spread premium to rise.

b. How is the discount rate determined after a credit event has occurred?

The discount rate for each year in the future in which cash flows are expected to be
received includes the forward rates from the current Treasury yield curve plus the annual
credit spreads for loans of a particular rating class for each year. These credit spreads are
determined by observing the spreads of the corporate bond market over Treasury securities.

c. Why does the probability distribution of possible loan values have a negative skew?

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 The negative skew occurs because the probability distribution is non-normal. The potential
downside change in a loan’s value is greater than the possible upside change in value.

d. How do the capital requirements of the CreditMetrics approach differ from those of the
BIS and Federal Reserve System?

The Fed and the BIS require the capital reserve to be 8 percent of the book value of the
loan. Under CreditMetrics each loan is likely to have a different VAR and thus a different
implied capital requirement. Further, this required capital is likely to be greater than 8
percent of book value because of the non-normality of the probability distributions.

37. A five-year fixed-rate loan of $100 million carries a 7 percent annual interest rate. The
borrower is rated BB. Based on hypothetical historical data, the probability distribution
given below has been determined for various ratings upgrades, downgrades, status quo, and
default possibilities over the next year. Information also is presented reflecting the forward
rates of the current Treasury yield curve and the annual credit spreads of the various
maturities of BBB bonds over Treasuries.
New Loan
Probability Value plus Forward Rate Spreads at time t
Rating Distribution Coupon $ t rt % st%
AAA 0.01% $114.82 1 3.00% 0.72%
AA 0.31% $114.60 2 3.40% 0.96%
A 1.45% $114.03 3 3.75% 1.16%
BBB 6.05% 4 4.00% 1.30%
BB 85.48% $108.55
B 5.60% $98.43
CCC 0.90% $86.82
Default 0.20% $54.12

a. What is the present value of the loan at the end of the one-year risk horizon for the case
where the borrower has been upgraded from BB to BBB?

$7 $7 $7 $107
PV =$7 + + 2
+ 3
+ =$113 .27 million
1.0372 (1.0436 ) (1.0491 ) (1.0530 ) 4

b. What is the mean (expected) value of the loan at the end of year one?

The solution table on the following page reveals a value of $108.06.

c. What is the volatility of the loan value at the end of the year?

The volatility or standard deviation of the loan value is $4.19.

d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal
distribution of values.

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 The 5 percent VAR is 1.65 x $4.19 = $6.91.
The 1 percent VAR is 2.33 x $4.19 = $9.76.

Probability
Year-end Probability * Deviation
Rating Probability Value * Value Deviation Squared
AAA 0.0001 $114.82 $0.01 6.76 0.0046
AA 0.0031 $114.60 $0.36 6.54 0.1325
A 0.0145 $114.03 $1.65 5.97 0.5162
BBB 0.0605 $113.27 $6.85 5.21 1.6402
BB 0.8548 $108.55 $92.79 0.49 0.2025
B 0.056 $98.43 $5.51 -9.63 5.1968
CCC 0.009 $86.82 $0.78 -21.24 4.0615
Default 0.002 $54.12 $0.11 -53.94 5.8197
1.000 Mean = $108.06 Variance = 17.5740
Standard Deviation = $4.19

e. Estimate the “approximate” 5 percent and 1 percent VARs using the actual distribution
of loan values and probabilities.

5% VAR = 95% of actual distribution = $108.06 - $102.02 = $6.04

1% VAR = 99% of actual distribution = $108.06 - $86.82 = $21.24

where: 5% VAR is approximated by 0.056 + 0.009 + 0.002 = 0.067 or 6.7 percent, and
1% VAR is approximated by 0.009 + 0.002 = 0.011 or 1.1 percent.

Using linear interpolation, the 5% VAR = $10.65 million and the 1% VAR = $19.31
million. For the 1% VAR, $19.31 = (1 – 0.1/1.1)*$21.24.

f. How do the capital requirements of the 1 percent VARs calculated in parts (d) and (e)
above compare with the capital requirements of the BIS and Federal Reserve System?

The Fed and BIS systems would require 8 percent of the loan value, or $8 million. The 1
percent VAR would require $19.31 million under the approximate method, and $9.76
million in capital under the normal distribution assumption. In each case, the amounts
exceed the Fed/BIS amount.

g. Go to the J.P. Morgan Chase website

(www.jpmorgan.com/RiskManagement/CreditMetrics). What data set information is
provided for use with CreditMetrics?

38. How does the Credit Risk+ model of Credit Suisse Financial Products differ from the
CreditMetrics model of J.P. Morgan?

Credit Risk attempts to estimate the expected loss of loans and the distribution of these losses
with the focus on calculating the required capital reserves necessary to meet these losses. The

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method assumes that the probability of any individual loan defaulting is random, and that the
correlation between the defaults on any pair of loan defaults is zero. CreditMetrics is focussed
on estimating a complete VAR framework.

39. An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have an historical
default rate of 4 percent, and the severity of loss is 40 cents per $1. Note: This question
refers to material in Appendix 11B.

a. Over the next year, what are the probabilities of having default rates of 2, 3, 4, 5, and 8
percent?

e −m m n ( 2.71828 ) −4 x 4 2 0.018316 x16

Pr obability of 2 defaults = = = = 0.1465
n! 1x 2 2

n 2 3 4 5 8
Probability 0.1465 0.1954 0.1954 0.1563 0.0298

b. What would be the dollar loss on the portfolios with default rates of 4 and 8 percent?

Dollar loss of 4 loans defaulting = 4 x 0.40 x $10,000 = $16,000

Dollar loss of 8 loans defaulting = 8 x 0.40 x $10,000 = $32,000

c. How much capital would need to be reserved to meet the 1 percent worst-case loss
scenario? What proportion of the portfolio’s value would this capital reserve be?

The probability of 8 defaults is ~3 percent. The probability of 10 defaults is 0.0106 or

close to 1 percent. The dollar loss of 10 loans defaulting is $40,000. Thus a 1 percent
chance of losing $40,000 exists.

A capital reserve should be held to meet the difference between the unexpected 1 percent
loss rate and the expected loss rate of 4 defaults. This difference is $40,000 minus $16,000
or $24,000. This amount is 0.024 percent of the total portfolio.

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