Solutions For End-of-Chapter Questions and Problems: Chapter Ten

Solutions for End-of-Chapter Questions and Problems: Chapter Ten
1. Why is credit risk analysis an important component of FI risk management? What recent
activities by FIs have made the task of credit risk assessment more difficult for both FI
managers and regulators?
Credit risk management is important for FI 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 markets are competitive and margins are low.
Credit risk does not apply only to traditional areas of lending and bond investing. As banks and
other FIs have expanded into credit guarantees and other off-balance-sheet activities, new types
of credit risk exposure have arisen, causing concern among managers and regulators. Credit
quality problems, in the worst case, can cause an FI to become insolvent or can result in such a
significant drain on capital and net worth that they adversely affect its growth prospects and
ability to compete with other domestic and international FIs.
2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a
fixed-rate loan? Why would FI managers 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.
Secured debt is senior to an unsecured loan (or junior debt) that has only a general claim on the
assets of the borrower if default occurs. With a fixed-rate loan, the lender bears the risk of
interest rate changes. If interest rates rise, the opportunity cost of lending is higher, while 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 loans and pass the interest rate risk on to the borrower. With
floating rate loans, the loan rate can be periodically adjusted according to a formula so that the
interest rate risk is transferred in large part from the FI 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 rates decline, the borrower can borrow
from other sources. The disadvantage is the cost: often 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 United States? What effect does
this decline have on overall commercial lending activities?
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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 by issuing
commercial paper. The total amount of commercial paper outstanding in the U.S. has grown
dramatically over the last thirty years. Historically, only the most creditworthy borrowers had
access 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 banks has become smaller and riskier. This makes the credit assessment and monitoring of
loans more difficult, yet important.
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 an interest rate
cycle? When would the ratio be highest?
Residential mortgage 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, 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 nonrevolving 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. Many banks often recognize high rates
of return on these loans, even though in recent years, banks have faced charge-off rates in the
four percent range.
7. Why are rates on credit card loans generally higher than rates on car loans?
Car loans are backed by collateral (the car), while credit card loans are not. Thus, in the event of
default on a car loan, the FI can take possession of the car to recoup at least some the lost interest
and principal payments. In the event of a default on a credit card loan, the FI has no such
collateral available with which to recover lost interest and principal payments. Accordingly, the
FI charges a higher rate on the credit card loan.
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?
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A compensating balance is the portion of a loan that a borrower must keep on deposit with the
credit-granting 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.
9. Suppose that a bank does the following:
a. Sets a loan rate on a prospective loan at 8 percent (where BR = 5% and ϕ = 3%).

b. Charges a 1/10 percent (or 0.10 percent) loan origination fee to the borrower.
c. Imposes a 5 percent compensating balance requirement to be held as noninterest-bearing
demand deposits.
d. Holds reserve requirements of 10 percent imposed by the Federal Reserve on the bank’s
demand deposits.
Calculate the bank’s ROA on this loan.
1 + k = 1 + 0.0010 + (0.05 + 0.03) = 1 + 0.081 = 1.0848 or k = 8.48%

1 - [(0.05)(1 - 0.10)] 0.955
10. 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? In each case, assume origination fees and the reserve requirement
are zero.
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 (= 9% ÷ (1.0 – 0.15)) and 11.25 percent (= 9% ÷ (1.0 – 0.2)), respectively. Note
that as the compensating balance rate increases by a constant amount, the true cost of the loan
increases at an increasing rate.
11. 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
hold a 6 percent reserve requirement at 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 + ϕ = 0.09 + 0.025 = 0.115 or 11.5%.
b. What is the contractually promised gross return on the loan per dollar lent?
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of + (BR + Φ) 0.0025 + (0.09 + 0.025) 0.1175
1+k = 1 + =1+ = 1+ = 1.1297
1 − [ b(1 − RR )] 1 − [0.1(1 − 0.06)] 0.906 or k = 0.1297 =
12.97%
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.
12. 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.
13. 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?
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. The lender often is able to charge fees that increase the return on the loan.
However, the fees may become sufficiently high as to increase the risk of nonpayment or default
on the loan.
14. What are covenants in a loan agreement? What are the objectives of covenants?
Covenants are restrictions that are written into loan or bond contracts that affect the actions of
the borrower. Covenants can include limits on the type and amount of new debt, investments,
and asset sales the borrower may undertake while the loan or bonds are outstanding. Financial
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covenants are also often imposed restricting changes in the borrower’s financial ratios such as its
leverage ratio or current ratio. For example, a common restrictive covenant included in many
bond and loan contracts limits the amount of dividends a firm can pay to its equity holders.
Clearly, for any given cash flow, a high dividend payout to stockholders means that less is
available for repayments to bondholders and lenders. Moreover, bond yields, like wholesale loan
rates, usually reflect risk premiums that vary with the perceived credit quality of the borrower
and the collateral or security backing of the debt. Given this, FIs can use many of the following
models that analyze default risk probabilities either in making lending decisions or when
considering investing in corporate bonds offered either publicly or privately.
15. 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.
a. Which of these factors is more likely to adversely affect 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?
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.
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.
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16. Why is the degree of collateral as specified in the loan agreement of importance to a
lender? If the book value of the collateral is greater than or equal to the amount of the loan,
is the credit risk of a 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.
17. 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. Further, Fed monetary
policy 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.
18. What are the purposes of credit scoring models? How do these models 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 of credit scoring models is to improve the
accuracy of predicting borrower’s performance without using additional resources. This benefit
results in fewer defaults and charge-offs 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.
19. Suppose there were two factors influencing the past default behavior of borrowers: the
leverage or debt–assets ratio (D/A) and the profit margin ratio (PM). Based on past default
(repayment) experience, the linear probability model is estimated as:
PDi = 0.105(D/Ai ) - 0.35(PMi )
Prospective borrower A has a D/A = 0.65 and a PM = 5%, and prospective borrower B has
a D/A = 0.45 and PM = 1%. Calculate the prospective borrowers’ expected probabilities of
default (PDi). Which borrower is the better loan candidate? Explain your answer.
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PDA = 0.105(0.65) - 0.35(0.05) = 0.05075 or 5.075%
PDB = 0.105(0.45) - 0.35(0.01) = 0.04375 or 4.375%
Prospective borrower B is the better loan candidate. Even though B’s profit margin is lower than
A’s, A’s higher debt-asset ratio increases the firm’s probability of default to be higher than firm
B’s.
20. Suppose the estimated linear probability model used by an FI to predict business loan
applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error, where X1 is the
borrower's debt/equity ratio, X2 is the volatility of borrower earnings, and X3 is the
borrower’s profit margin. For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 =
0.10.
a. What is the projected probability of default for the borrower?
PD = 0.03(0.75) + 0.02(0.25) – 0.05(0.10) = 0.0225
b. What is the projected probability of repayment if the debt/equity ratio is 2.5?
PD = 0.03(2.5) + 0.02(0.25) - 0.05(0.10) = 0.075

The expected probability of repayment is 1 - 0.075 = 0.925.
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 percent or
above 100 percent, an occurrence that does not make economic or statistical sense.
21. Describe how a linear discriminant analysis model works. Identify and discuss the
criticisms which 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 of borrowers. 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, no centralized
database on defaulted business loans for proprietary and other reasons exists. This constrains the
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ability of many FIs to use traditional credit scoring models (and quantitative models in general)
for larger business loans.
22. Suppose that the financial ratios of a potential borrowing firm take the following values:
Working capital/total assets ratio (X1) = 0.75

Retained earnings/total assets ratio (X2) = 0.10
Earnings before interest and taxes/total assets ratio (X3) = 0.05
Market value of equity/book value of total liabilities ratio (X4) = 0.10
Sales/total assets ratio (X5) = 0.65
Calculate the Altman’s Z score for the borrower in question. How is this number a sign of
the borrower’s default risk?
Z = 1.2(0.75) + 1.4(0.10) + 3.3(0.05) + 0.6(0.10) + 1.0(0.65) = 0.90 + 0.14 + 0.165 + 0.06 + 0.65
= 1.915
With a Z score between 1.81 and 2.99, the firm is in the indeterminant default risk region. The
ratios X2 and X3 are small, indicating that the firm has low earnings or even losses in recent
periods. The ratio X5 indicates that the firm may be unable to produce sales efficiently. Also, X4
indicates that the borrower is highly leveraged. Finally, the working capital ratio (X1) is high,
indicating that the firm is investing the large majority of its funding in zero or low earning assets.
The FI should not make a loan to this borrower until it improves its earnings.
23. MNO Inc., a publicly traded manufacturing firm in the United States, has provided the
following financial information in its application for a loan. All numbers are in thousands
of dollars.
Assets Liabilities and Equity

Cash $ 20 Accounts payable $ 30
Accounts receivables 90 Notes payable 40
Inventory 90 Accruals 30
Long-term debt 150
Plant and equipment 500 Equity (ret. earnings = $300) 450
Total assets $700 Total liabilities and equity $700
Also assume sales = $500,000; cost of goods sold = $360,000; 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 - Current liabilities.

Current assets = Cash + Accounts receivable + Inventories.
Current liabilities = Accounts payable + Accruals + Notes payable.
EBIT = Revenues - Cost of goods sold.
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Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
All numbers are in $000s.
X1 = (20 + 90 + 90 – 30 – 40 – 30) / 700 = 0.1429 X1 = Working capital/total assets (TA)

X2 = 300 / 700 = 0.4286 X2 = Retained earnings/TA
X3 = (500 – 360) / 700 = 0.20 X3 = EBIT/TA
X4 = 450 / (30+40+30+150) = 1.80 X4 = Market value of equity/Book value of long-term debt
X5 = 500 / 700 = 0.7143 X5 = Sales/TA
Z = 1.2(0.1429) + 1.4(0.4286) + 3.3(0.20) + 0.6(1.80) + 1.0(0.7143) = 3.2257

= 0.1714 + 0.6000 + 0.6600 + 1.0800 + 0.7143 = 3.2257
b. Based on the Altman’s Z score only, should you approve MNO Inc.'s application to
your bank for a $500,000 capital expansion loan?
Since the Z score of 3.2257 is greater than 2.99, ABC Inc.’s application for a capital expansion
loan should be approved.
c. If sales for MNO were $250,000, the market value of equity was only half of book
value, and all other values are unchanged, would your credit decision change?
ABC’s EBIT would be $300,000 - $360,000 = -$60,000.
X1 = (20 + 90 + 90 - 30 - 40 - 30) / 700 = 0.1429

X2 = 300 / 700 = 0.4286
X3 = -110 / 700 = -0.1571
X4 = 225 / (30+40+30+150) = 0.9000
X5 = 250 / 700 = 0.3571
Z = 1.2(0.1429) + 1.4(0.4286) + 3.3(-0.1571) + 0.6(0.9000) + 1.0(0.3571) = 1.1500
Since ABC's Z-score falls to 1.1500 < 1.81, credit should be denied.
d. Would the discriminant function change for firms in different industries? Would the
function be different for manufacturing firms in different geographic sections of the
country? What are the implications for the use of these types of models by FIs?
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 yes
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
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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.
24. 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.
25. If the rate on one-year Treasury strips 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 zero coupon bond yielding 9.5 percent.
Probability of repayment = p = (1 + i)/(1 + k)

For an AA-rated bond = (1 + 0.06)/ (1 + 0.095) = 0.9680, or 96.80 percent
=> probability of default = 1 – 0.9680 = 0.0320, or 3.20%
The market determined risk premium is 0.095 – 0.060 = 0.035 or 3.5 percent. This implies a
probability of default of 3.2 percent on an AA-rated corporate bond requires an FI to set a risk
premium of 3.5 percent.
b. One-year BB-rated zero coupon bond yielding 13.5 percent.
Probability of repayment = p = (1 + i)/(1 + k)

For BB-rated bond = (1 + 0.06)/(1 + 0.135) = 93.39 percent
=> probability of default = 1 – 0.9339 = 0.0661, or 6.61%
The market determined risk premium is 0.135 – 0.060 = 0.075 or 7.50 percent. This implies a
probability of default of 6.61 percent on a BB-rated corporate bond requires an FI to set a risk
premium of 7.5 percent.
26. 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?
E(r) = p(1 + k) + (1 - p)(1 + k)(γ) where γ is the percentage generated when the loan is defaulted.
E(r) = 0.95(1 + 0.10) + 0.05(1 + 0.10)(0.50) = 1.0450 + 0.0275 = 1.0725 - 1.0 = 7.25%
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27. Assume a one-year Treasury strip is currently yielding 5.5 percent and an 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) +  (1 - p)(1 + k) = 1 + i. Solving for the probability of repayment (p):
1+i 1.055
−γ − 0.5
1+k 1.085
p= = = 0.9447 or 94 .47 percent
1− γ 1 −0.5
Therefore the probability of default is 1.0 - 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?
1+i 1.055
−γ − 0.9447
1+k 1.085
p= = = 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 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.
28. 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 a given year, whereas cumulative
default probability is the probability of default across several years. For example, the cumulative
default probability across two years is given below, where (pt) is the probability of nondefault in
a given year.
Cp = 1 – (p1) (p2)
29. Suppose an FI manager wants to find the probability of default on a two-year loan. For the
one-year loan, 1 - p1 = 0.03 is the marginal and total or cumulative probability (Cp) of
default in year 1. For the second year, suppose that 1 - p2 = 0.05. Calculate the cumulative
probability of default over the next two years.
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1 - p1 = 0.03 = marginal probability of default in year 1
1 - p2 = 0.05 = marginal probability of default in year 2
The probability of the borrower surviving—not defaulting at any time between now (time 0) and
the end of year 2—is: p1 × p2 = (0.97)(0.95) = 0.9215. Thus,
Cp = 1- [(0.97)(0.95)] = 0.785, or 7.85%
There is an 7.85 percent probability of default over this period.
30. From the Treasury strip yield curve, the current required yields on one- and two-year
Treasuries are i1 = 4.65 percent and i2 = 5.50 percent, respectively. Further, the current
yield curve indicates that appropriate one-year discount bonds are yielding k1 = 8.5 percent,
and two-year bonds are yielding k2 = 10.25 percent.
a. Calculate the one-year forward rate on the Treasuries and the corporate bond.
The one-year forward rate, f1, on the Treasury is:
f1 = (1.0550)2 / 1.0465 = 1.06357 - 1, or f1 = 6.357%
The one-year forward rate, c1, on the corporate bond is:
c1 = (1.1025)2 / 1.0850 = 1.12028 - 1, or c1 = 12.028%
b. Using the current and forward one-year rates, calculate the marginal probability of
repayment on the corporate bond in years 1 and 2, respectively.
The probability of repayment in year 1 is:
p1 = 1.0465 / 1.085 = 0.9645 , or probability of default = 1 – 0.9645 = 5.35%
The marginal probability of repayment in year 2 is:
p2 = (1.06357) / 1.12028 = 0.9494 , or probability of default = 1 – 0.9494 = 5.06%
c. Calculate the cumulative probability of default on the corporate bond over the next two
years.
The probability of the borrower surviving—not defaulting at any time between now (time 0) and
the end of year 2—is: p1 × p2 = (0.9645)(0.9494) = 0.9157. Thus,
Cp = 1- [(0.9645)(0.9494)] = 0.843, or 8.43%
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31. 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

Treasury strips 5.0% 6.1% 7.0%
BBB-rated bonds 7.0 8.2 9.3
The notation used for implied forward rates on Treasuries is f1 = forward rate from period 1 to
period 2 and on corporate bonds is c1 = forward rate from period 1 to period 2.
Treasury strips BBB-rated debt

(1.061)2 = (1.05)(1 + f1) (1.082)2 = (1.07)(1 + c1)
f1 = 7.21% c1 = 9.41%
(1.07)3 = (1.061)2(1 + f2) (1.093)3 = (1.082)2(1 + c2)

f2 = 8.82% c2 = 11.53%
Using the implied forward rates, estimate the annual marginal probability of repayment:
p1(1.07) = 1.05 => p1 = 98.13 percent

p2(1.0941) = 1.0721 => p2 = 97.99 percent
p3 (1.1153) = 1.0882 => p3 = 97.57 percent
Using marginal probabilities, estimate the cumulative probability of default:
Cp2 = 1 - (p1)(p2)
= 1 - (0.9813)(0.9799) = 3.84 percent
Cp3 = 1 - (p1)(p2)(p3)
= 1 - (0.9813)(0.9799)(0.9757) = 6.18 percent
32. 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.
Education
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, c, for the corporate bond for the 82-day period is:
(1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + c)82/365  c = 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 - 0.9992) = 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 - 0.9976) = 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 = 0.9984, or 99.84 percent
Therefore, the probability of default is (1 - p) or 0.0016 or 0.16 percent.
33. 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.
34. 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%
Education
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: Annual 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%
The annual survival rate is pt = 1 – annual default rate, and the cumulative default rate for:
n = 3 of commercial loans is 1 – (p1 x p2 x p3) = 1 - (1 x 0.999 x 0.995) = 0.005995 = 0.60%
n = 4 of commercial loans is 1 – (p1 x p2 x p3 x p4) = 1 - (1 x 0.999 x 0.995 x p4) = 0.008
=> p4 = (1 – 0.008)/ (1 x 0.999 x 0.995) = 0.99798
=> annual default rate = 1 - 0.99798 = 0.0020 = 0.20%
n = 5 of commercial loans is 1 – (p1 x p2 x p3 x p4 x p5)
= 1 - (1 x 0.999 x 0.995 x 0.99798 x 0.997) = 0.0110 = 1.10%
n = 2 of mortgage loans is 1 – (p1 x p2) = 1 – (0.999 x 0.9975) = 0.0035 = 0.35%

n = 3 of mortgage loans is = 1 – (p1 x p2 x p3) = 1 - (0.999 x 0.9975 x 0.9940) = 0.0095 = 0.95%
n = 4 of mortgage loans is 1 – (p1 x p2 x p3 x p4) = 1 - (0.999 x 0.9975 x 0.9940 x p4) = 0.0164
=> p4 = (1 – 0.0164)/ (0.999 x 0.9975 x 0.9940) = 0.9930
=> annual default rate = 1 - 0.9930 = 0.0070 = 0.70%
n = 5 of commercial loans is 1 – (p1 x p2 x p3 x p4 x p5)
= 1 - (0.999 x 0.9975 x 0.9940 x 0.9930 x 0.992) = 0.0243 = 2.43%
b. What are the probabilities that each type of loan will not be in default after five years?
The cumulative survival rate is = (1 - MMR1) x (1 - MMR2) x (1 - MMR3) x (1 - MMR4) x (1 - MMR5)

where MMR = marginal mortality rate
Commercial loan = (1 - 0.00) x (1 - 0.001) x (1 - 0.005) x (1 - 0.002) x (1 - 0.003) = 0.989 or 98.9%.
Mortgage loan = (1 - 0.001) x (1 - 0.0025) x (1 - 0.006) x (1 - 0.007) x (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 - 0.000)(1 - 0.0010)(1 - 0.0050)(1 - 0.0020)
= 1- 0.9920 = 0.0080 or 0.80 percent.
For mortgage loan = 1- (1 - 0.0010)(1 - 0.0025)(1 - 0.0060)(1 - 0.0070)

= 1- 0.98359 = 0.01641 or 1.64 percent.
Education
The difference in cumulative default rates is 1.64 - 0.80 = 0.84 percent.
35. 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.
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

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

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
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
1 1 100,000 0.000010 0.999990 0.000010 0.0010%
2 3 97,000 0.000031 0.999969 0.000041 0.0041%
Education
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%

Bond Type 1 Year 2 Years 3 Years 4 Years 5 Years
A-rated: Annual default 0% 0% 0% 0.0011% 0.0023%
Cumulative default 0% 0% 0% 0.0011% 0.0034%
B-rated: Annual default 0% 0.0011% 0.0022% 0.0034% 0.0047%

Cumulative default 0% 0.0011% 0.0032% 0.0066% 0.0113%
C-rated: Annual 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.
36. 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 LN in the RAROC equation?
RAROC is a measure of expected loan net income in the form of interest plus fees less cost of
funding 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. While the loan’s duration and the loan amount are easily estimated, it is more
difficult to estimate the maximum change in the credit risk premium on the loan over the next
year. Since publicly available data on loan risk premiums are scarce, we turn to publicly
available corporate bond market data to estimate premiums. First, an S&P credit rating (AAA,
AA, A, and so on) is assigned to a borrower. Thereafter, the available risk premium changes of
all the bonds traded in that particular rating class over the last year are analyzed. The change in
credit quality (R) 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, 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.
Net Income ΔR
RAROC = where Δ LN = −D LN x LN x where R is the change in yield spread .
Loan risk (or Δ LN ) 1+R
Education
37. An FI wants to evaluate the credit risk of a $5 million loan with a duration of 4.3 years to a
AAA borrower. There are currently 500 publicly traded bonds in that class (i.e., bonds
issued by firms with a AAA rating). The current average level of rates (R) on AAA bonds
is 8 percent. The largest increase in credit risk premiums on AAA loans, the 99 percent
worst-case scenario, over the last year was equal to 1.2 percent (i.e., only 6 bonds out of
500 had risk premium increases exceeding the 99 percent worst case). The projected (one-
year) spread on the loan is 0.3 percent and the FI charges 0.25 percent of the face value of
the loan in fees. Calculate the capital at risk and the RAROC on this loan.
The estimate of loan (or capital) risk is:
ΔLN = -DLN x LN x (ΔR/(1 + R)) = -4.3 x $5m x (0.012/(1 + 0.08)) = $238,889
While the market value of the loan amount is $5 million, the risk amount, or change in the loan’s
market value due to a decline in its credit quality, is $238,889. Thus, the denominator of the
RAROC equation is this possible loss, or $238,889. To determine whether the loan is worth
making, the estimated loan risk is compared with the loan’s income (spread over the FI’s cost of
funds plus fees on the loan).
Spread = 0.003 x $5 million = $15,000

Fees = 0.0025 x $5 million = $12,500
$27,500
The loan’s RAROC is:
RAROC = $27,500/238,889 = 11.51%
38. 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?
RAROC = Fees and interest earned on loan/Loan or capital risk
Loan risk, or LN = -DLN x LN x (R/(1 + R)) = -7.5 x $5m x (0.042/1.12) = -$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.
Education
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 x LN x (R/(1 + R)) = 1,250,000
DLN = 1,250,000/(5,000,000 x (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.
c. Assuming that duration cannot be changed, how much additional interest and fee
income will be necessary to make the loan acceptable?
Necessary RAROC = Income/Risk  Income = RAROC x Risk

= $1,406,250 x 0.10 = $140,625
Therefore, additional income = $140,625 - $125,000 = $15,625, or
$15,625/$5,000,000 = 0.003125 = 0.3125%.
Thus, this loan can be made if fees are increased from 50 basis points to 81.25 basis points.
d. Given the proposed income stream and the negotiated duration, what adjustment in the
loan rate would be necessary to make the loan acceptable?
Need an additional $15,625 => $15,625/$5,000,000 = 0.003125 or 0.3125%

Servicing fees = 0.0050 x $5,000,000 = $25,000
Net interest and fee income = $140,625
RAROC = $140,625/1,406,250 = 10.00 percent = cost of funds to the bank. Thus, increasing the
loan rate from 12% to 12.3125% will make the loan acceptable
39. Calculate the value of and interest rate on a loan using the option model and the following
information.
Face value of loan (B) = $500,000

Length of time remaining to loan maturity (τ) = 4 years
Risk-free rate (i) = 4%
Borrower’s leverage ratio (d) = 51%
Standard deviation of the rate of change in the value of the underlying assets = 15%
Substituting these values into the equations for h1 and h2 and solving for the areas under the
standardized normal distribution, we find that:
Education
h1 = -[0.5 x (0.15)2 x 4 - ln(0.51)]/(0.15)(4)1/2 = -2.39448
h2 = -[0.5 x (0.15)2 x 4 + ln(0.51)]/(0.15)(4)1/2 = 2.09448
h N(h) h N(h)
-2.40 0.0082 2.00 0.9773
-2.35 0.0094 2.05 0.9798
-2.30 0.0107 2.10 0.9821
-2.25 0.0122 2.15 0.9842
Current market value of loan = L(τ) = Be-iτ [N(h1)1/d + N(h2)]

= $500,000 e-0.04(4) [N(-2.39448) x 1.6667 + N(2.09448)]
= $426,071.89[0.008332 x 1.6667 + 0.981846] = $424,254
The risk premium, ϕ = k(τ) – i = (-1/τ) ln[N(h2) + (1/d)N(h1)]

= (-1/4)ln[0.981846 + 0.008332 x 1.6667] = 0.001069 = 0.1069%
Thus, the risky loan rate k(τ) should be set at 4.1069 percent when the risk-free rate (i) is 4
percent.
40. A firm is issuing a two-year loan in the amount of $200,000. The current market value of
the borrower’s 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.
The following need to be estimated first: d, h1 and h2 .

d = Be-iτ /A = $200,000e-0.04(2)/300,000 = 0.6154 or 61.54 percent.
h1 = -[0.5 x (0.20)2 x 2 - ln(0.6154)]/(0.20)(2)1/2 = -1.8578
h2 = -[0.5*(0.20)2 *2 + ln(0.6154)]/(0.20)(2)1/2 = 1.5750
= $184,623.27[N(-1.8578) x 1.62493 + N(1.5750)]
= $184,623.27[0.031654 x 1.62493 + 0.94265] = $183,531
The risk premium, ϕ = k(τ) – i = (-1/τ) ln[N(h2) + (1/d)N(h1)]

= (-½)ln[0.94265 + 1.62493 x 0.031654] = 0.002966 = 0.2966%
41. A firm has assets of $200,000 and total debt of $175,000. With an option pricing model,
the implied volatility of the value of the firm’s assets is estimated at $10,730. Under the
Education
Moody’s Analytics 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 falls below $175,000. If  =
$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.
42. Carman County Bank (CCB) has a $5 million face value outstanding 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
-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 .

D = 0.80
h1 = -[0.5 x (0.12)2 x 0.5 - ln(0.8)]/(0.12)0.5 = -0.226744/0.084853 = -2.6722
h2 = -[0.5 x (0.12)2 x 0.5 + ln(0.8)]/(0.12)0.5 = 0.219544/0.084853 = 2.5873
= $4,852,227.67[N(-2.6722) x 1.25 + N(2.5873)]
= $4,852,227.67 [0.003778 x 1.25 + 0.995123]
= $4,851,478
b. What should be the interest rate for the last six months of the loan?
The risk premium k(τ) – i = (-1/τ) ln[N(h2) + (1/d)N(h1)]

= (-1/0.5)ln[0.995123 + 1.25 x 0.003778] = 0.0003
The loan rate = risk-free rate plus risk premium = 0.06 + 0.0003 = 0.0603 or 6.03%.
The questions and problems that follow refer to Appendix 10A.
43. Suppose you are a loan officer at Carbondale Local Bank. Joan Doe listed the following
information on her mortgage application.
Education
Characteristic Value
Annual gross income $45,000
TDS 10%
Relations with FI Checking account
Major credit cards 5
Age 27
Residence Own/mortgage
Length of residence 2½ years
Job stability 5½ years
Credit history Missed 2 payments 1 year ago
Education
Use the information below to determine whether or not Joan Doe should be approved for a mortgage from your bank.
Characteristic Characteristic Values and Weights
Annual gross <$10,000 $10,000-$25,000 $25,000-$50,000 $50,000-$100,000 >$100,000

income
Score 0 10 20 35 60
TDS >50% 35%-50% 15%-35% 5%-15% <5%
Score -10 0 20 40 60
Relations None Checking account Savings account Both
with FI
Score 0 10 10 20
Major credit None Between 1 and 4 5 or more
cards
Score 0 20 10
Age <25 25-60 >60
Score 5 25 35
Residence Rent Own with mortgage Own outright
Score 5 20 50
Length of <1 year 1-5 years >5 years
residence
Score 0 25 40
Job stability <1 year 1-5 years >5 years
Score 0 25 50
Credit history No record Missed a payment Met all payments
in last 5 years
Score 0 -15 40
21
The loan is automatically rejected if the applicant’s total score is less than or equal to 120; the loan is automatically approved if the
total score is greater than or equal to 190. A score between 120 and 190 (noninclusive) is reviewed by a loan committee for a final
decision.
22
Jane Doe=s credit score is calculated as follows:
Characteristic Value Score

Annual gross income $45,000 20
TDS 10% 40
Relations with FI Checking account 10
Major credit cards 5 10
Age 27 25
Residence Own/Mortgage 20
Length of residence 2½years 25
Job stability 5½ years 50
Credit history Missed 2 payments 1 year ago -15
Score 185
The loan request will go to the credit committee for review and decision.
44. What are some of the special risks and considerations when lending to small businesses
rather than mid-market businesses?
Small business loans are more complicated because the FI is frequently asked to assume the
credit risk of an individual whose business cash flows require considerable analysis, often with
incomplete accounting information available to the credit officer. The payoff for this analysis is
also small, by definition, because loan principal amounts are usually small. A $50,000 loan with
a 3 percent interest spread over the cost of funds provides only $1,500 of gross revenues before
loan loss provisions, monitoring costs, and allocation of overheads. This low profitability has
caused many FIs to build small business scoring models similar to, but more sophisticated than,
those used for mortgages and consumer credit. These models often combine computer-based
financial analysis of borrower financial statements with behavioral analysis of the owner of the
small business.
Besides the obvious difference in the sizes of the borrowers, mid-market businesses have a
recognizable corporate structure (unlike many small businesses), but do not have ready access to
deep and liquid capital markets. Further, while still assessing the character of the firm’s
management, the main focus for mid-market loans is on the business itself. The large business
borrower is also more likely to have a track record to use as a basis for future performance.
45. How does ratio analysis help to answer questions about the production, management, and
marketing capabilities of a prospective borrower?
Historical financial statement analysis can be useful in determining whether cash flow and profit
projections are plausible on the basis of the history of the applicant and in highlighting the
applicant’s risks. Calculation of financial ratios is useful when performing financial statement
analysis on a mid-market corporate applicant. Although stand-alone accounting ratios are used
for determining the size of the credit facility, the analyst may find relative ratios more
informative when determining how the applicant’s business is changing over time (i.e., time
series analysis) or how the applicant’s ratios compare to those of its competitors (i.e., cross-
sectional analysis). Ratios are particularly informative when they differ either from an industry
average (or FI-determined standard of what is appropriate) or from the applicant’s own past
history. An optimal value is seldom given for any ratio because no two companies are identical.
A ratio that differs from an industry average or an FI-determined standard, however, normally
raises a “flag” and causes the account officer to investigate further. For example, a ratio that
shifts radically from accounting period to accounting period may reveal a company weakness.
Although financial ratios are normally thought to represent financial health, they also
demonstrate other aspects of the company’s health. Generally, a set of healthy ratios should
reflect a well-managed company. A company with strong profits, an ability to pay off its debt,
and an above average turnover of assets should be in a good position to meet future obligations.
More specifically, the profitability and asset management ratios reflect the production efficiency
of management. Receivables turnover and days sales outstanding are indicators of the company’s
credit policy and collection policies and are also indicative of the marketing efficiency of the
company.
46. Consider the following company balance sheet and income statement.
Balance Sheet:
Assets Liabilities and Equity
Cash $4,000 Accounts payable $30,000
Accounts receivable 52,000 Notes payable 12,000
Inventory 40,000 Total current liabilities 42,000
Total current assets 96,000 Long-term debt 36,000
Fixed assets 44,000 Equity 62,000
Total assets $140,000 Total liabilities and equity $140,000
Income Statement
Sales (all on credit) $200,000
Cost of goods sold 130,000
Gross margin 70,000
Selling and administrative expenses 20,000
Depreciation 8,000
EBIT 42,000
Interest expense 4,800
Earning before tax 37,200
Taxes 11,160
Net income $26,040
For this company, calculate the following:
a. Current ratio.
96,000/42,000 = 2.2857X
b. Number of days' sales in receivables.
52,000 x 365/200,000 = 94.90 days
c. Sales to total assets.
200,000/140,000 = 1.4286X
d. Number of days in inventory.
40,000 x 365/130,000 = 112.31 days
e. Debt to assets ratio.
(42,000 + 36,000)/140,000 = .5571 = 55.71%
f. Cash flow to debt ratio.
(42,000 + 8,000)/(42,000 + 36,000) = .6410 = 64.10%
g. Return on assets.
26,040/140,000 = 0.1860 = 18.60%
h. Return on equity.
26,040/62,000 = 0.4200 = 42.00%
47. Industrial Corporation has an income to sales (profit margin) ratio of 0.03, a sales to assets
(asset utilization) ratio of 1.5, and a debt to asset ratio of 0.66. What is Industrial’s return
on equity?
ROE = NI/Equity = NI/Sales x Sales/Total assets x Total assets/Equity = PM  AU  EM

= 0.03 x 1.5 x (1/(1 - 0.66)) = 0.1324 = 13.24%
Answer to Integrated Mini Case: Loan Analysis
Loan:
1. PD = -0.08(2.15) + 0.15(0.45) + 1.25(0.13) - 0.45(0.12) = 0.004 = 0.4% < 0.5% => accept the loan
2. Z = 1.2((40m+120m+210m-55m-60m-70m)/1470m) + 1.4(200m/1470m) + 3.3((1250m-

930m) /1470m) + 0.6(2.2x735m/(55m+60m+70m+550m) + 1.0(1250m/1470m) = 0.1510 +
0.1905 + 0.7184 + 1.32 + 0.8503 = 3.2302 > 2.99 => accept the loan
3. Cumulative default probability = 0.595% < 1.25% => accept the loan
4. LN = -4.5 x $2m x (0.055/1.10) = -$450,000

Servicing fees = 0.0075 x $2,000,000 = $15,000
Net interest and fee income = $ 55,000
RAROC = $55,000/450,000 = 12.22 percent. Since RAROC is greater than the cost of
funds to the bank, 8%, the bank should make the loan.
The bank should accept all four of the loans.

Solutions For End-of-Chapter Questions and Problems: Chapter Ten

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Solutions For End-of-Chapter Questions and Problems: Chapter Ten

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What are the primary characteristics of residential mortgage loans?

What are the primary characteristics of residential mortgage loans?

What is the difference between a secured and unsecured loan?

What is the difference between a secured and unsecured loan?

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

9. Suppose that a bank does the following:

a. Sets a loan rate on a prospective loan at 8 percent (where BR = 5% and ϕ = 3%).

Calculate the bank’s ROA on this loan.

1 + k = 1 + 0.0010 + (0.05 + 0.03) = 1 + 0.081 = 1.0848 or k = 8.48%

The borrower-specific factors are:

Market-specific factors include:

Business cycle: Lenders are less likely to lend if a recession is forecasted.

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

PDi = 0.105(D/Ai ) - 0.35(PMi )

PDB = 0.105(0.45) - 0.35(0.01) = 0.04375 or 4.375%

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

PD = 0.03(0.75) + 0.02(0.25) – 0.05(0.10) = 0.0225

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

PD = 0.03(2.5) + 0.02(0.25) - 0.05(0.10) = 0.075

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

Working capital/total assets ratio (X1) = 0.75

Assets Liabilities and Equity

Net working capital = Current assets - Current liabilities.

X1 = (20 + 90 + 90 – 30 – 40 – 30) / 700 = 0.1429 X1 = Working capital/total assets (TA)

Z = 1.2(0.1429) + 1.4(0.4286) + 3.3(0.20) + 0.6(1.80) + 1.0(0.7143) = 3.2257

ABC’s EBIT would be $300,000 - $360,000 = -$60,000.

X1 = (20 + 90 + 90 - 30 - 40 - 30) / 700 = 0.1429

Z = 1.2(0.1429) + 1.4(0.4286) + 3.3(-0.1571) + 0.6(0.9000) + 1.0(0.3571) = 1.1500

a. One-year AA-rated zero coupon bond yielding 9.5 percent.

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

b. One-year BB-rated zero coupon bond yielding 13.5 percent.

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

p(1 + k) +  (1 - p)(1 + k) = 1 + i. Solving for the probability of repayment (p):

Therefore the probability of default is 1.0 - 0.9447 = 0.0553 or 5.53 percent.

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

Cp = 1- [(0.97)(0.95)] = 0.785, or 7.85%

There is an 7.85 percent probability of default over this period.

The one-year forward rate, f1, on the Treasury is:

f1 = (1.0550)2 / 1.0465 = 1.06357 - 1, or f1 = 6.357%

The one-year forward rate, c1, on the corporate bond is:

c1 = (1.1025)2 / 1.0850 = 1.12028 - 1, or c1 = 12.028%

The probability of repayment in year 1 is:

p1 = 1.0465 / 1.085 = 0.9645 , or probability of default = 1 – 0.9645 = 5.35%

The marginal probability of repayment in year 2 is:

p2 = (1.06357) / 1.12028 = 0.9494 , or probability of default = 1 – 0.9494 = 5.06%

Cp = 1- [(0.9645)(0.9494)] = 0.843, or 8.43%

Spot 1 Year Spot 2 Year Spot 3 Year

Treasury strips BBB-rated debt

(1.07)3 = (1.061)2(1 + f2) (1.093)3 = (1.082)2(1 + c2)

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

Using marginal probabilities, estimate the cumulative probability of default:

93 Days 175 Days

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

(1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + c)82/365  c = 8.933%

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

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

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

Years after Issuance

a. Complete the blank spaces in the table.