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Problem set 8- Credit Risk II:

Past exam questions:


1. There are two pure-discount bonds (i.e., zero-coupon bonds) issued by the same firm, one with one
year to maturity, and the other one with two years to maturity. Two bonds have the same seniority in
terms of payments (i.e., they have same levels of credit risk). If the issuer defaults, both bonds are
expected to lose all the claims on principal and interests. The yield to maturity for the 2-year bond is 10%
per annum. The 1-year risk free spot rate is 4%, and the risk-free forward rate in the 2nd year is 4.7%
according to the current term structure of interest rates. What is the expected probability of default of
the 2-year bond over its 2-year life according to term structure model of credit risk?

2. Suppose that an FI holds two loans with the following characteristics.

Loa Weight Loan Annual LGD EDF


n Spread Fee
1 0.45 5.50% 2.25% 30 3.50
% %
2 0.55 3.50% 1.75% 20 1%
%

Answer each of the following:

a) The correlation of return between the two loans is 12 = -0.20


Loan spread is the annual spread between loan rate and FIs cost of funds.
Calculate of the return and risk on the two-asset portfolio using Moodys Analytics Portfolio Manager
model.
b) The correlation of return between the two loans is 12 = 0.20
Loan spread is the annual spread between loan rate and FIs cost of funds.
Calculate of the return and risk on the two-asset portfolio using Moodys Analytics Portfolio Manager
model.
c) The correlation of return between the two loans is 12 = 0
Loan spread is the annual spread between loan rate and FIs cost of funds.
Calculate of the return and risk on the two-asset portfolio using Moodys Analytics Portfolio Manager
model.
d) Based on your findings in (a), (b) and (c), when do you think maximum diversification benefit
may be achieved?

End-of-chapter questions:

Chapter 10, Q25(a)


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.
b. One-year BB-rated zero coupon bond yielding 13.5 percent.
Chapter 10, Q27(a)
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?

Chapter 10, Q30


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.
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.
c. Calculate the cumulative probability of default on the corporate bond over the next two
years.

Chapter 11, Q4(a)


4. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of
capital.
a. If the average historical losses in the automobile sector total 8 percent, what is the
maximum loan a manager can lend to firms in this sector as a percentage of total
capital?

Chapter 11, Q13


13. Suppose that an FI holds two loans with the following characteristics.
Annual
Spread between Loss to FI Expected
Loan Rate and FIs Annual Given Default
Loan Xi Cost of Funds Fees Default Frequency
1 0.45 5.5% 2.25% 30% 3.5% 12 = -0.15
2 0.55 3.5 1.75 20 1.0
Calculate of the return and risk on the two-asset portfolio using Moodys Analytics
Portfolio Manager.

Chapter 11, Q15


15. Suppose that an FI holds two loans with the following characteristics.

Annual
Spread between Loss to FI Expected
Loan Rate and FIs Annual Given Default
Loan Xi Cost of Funds Fees Default Frequency
1 ? 4.0% 1.50% ?% 4.0% 12 = -0.10
2 ? 2.5 1.15 ? 1.5

The return on loan 1 is R1 = 6.25%, the risk on loan 2 is 2 = 1.8233%, and the return of the
portfolio is Rp = 4.555%. Calculate of the loss given default on loans 1 and 2, the proportions of
loans 1 and 2 in the portfolio, and the risk of the portfolio, p, using Moodys Analytics Portfolio
Manager.

Chapter 11, Q17(a)


17. Information concerning the allocation of loan portfolios to different market sectors is given
below:
Allocation of Loan Portfolios in Different Sectors (%)
Sectors National Bank A Bank B
Commercial 30% 50% 10%
Consumer 40 30 40
Real Estate 30 20 50

Bank A and Bank B would like to estimate how much their portfolios deviate from the national
average.
a. Which bank is further away from the national average?

Chapter 11, Q19


19. Over the past 10 years, a bank has experienced the following loan losses on its C&I loans,
consumer loans, and total loan portfolio.
Year C&I Loans Consumer Loans Total Loans

2015 0.0080 0.0165 0.0075


2014 0.0088 0.0183 0.0085
2013 0.0100 0.0210 0.0100
2012 0.0120 0.0255 0.0125
2011 0.0104 0.0219 0.0105
2010 0.0084 0.0174 0.0080
2009 0.0072 0.0147 0.0065
2008 0.0080 0.0165 0.0075
2007 0.0096 0.0201 0.0095
2006 0.0144 0.0309 0.0155

Using regression analysis on these historical loan losses, the bank has estimated the following:
XC = 0.002 + 0.8XL and Xh = 0.003 + 1.8XL
where XC = loss rate in the commercial sector, X h = loss rate in the consumer (household) sector,
XL = loss rate for its total loan portfolio.
a. If the banks total loan loss rates increase by 10 percent, what are the expected loss rate
increases in the commercial and consumer sectors?

b. In which sector should the bank limit its loans and why?