RM Quiz 4 Chappa Content

Chapter 10, 11 and 12
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 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 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.
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.
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.
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Education.
4. Why is commercial lending declining in importance in the U.S.? What effect does this
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 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. 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.
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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?
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:
1. Sets a loan rate on a prospective loan at 8 percent (where BR = 5% and ϕ = 3%).

2. Charges a 1/10 percent (or 0.10 percent) loan origination fee to the borrower.
3. Imposes a 5 percent compensating balance requirement to be held as noninterest-bearing
demand deposits.
4. Pays 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)(0.9)] 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 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.
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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?
of + (BR + ) 0.0025 + (0.09 + 0.025) 0.1175

1 + k =1 + =1 + =1 + =1.1297 or k = 0.1297 = 12.97%
1 − [b(1 − RR )] 1 − [0.1(1 − 0.06)] 0.906
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.
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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? 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. 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? How can
these covenants be negative? Positive?
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 lender, 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 lender in the monitoring and
control of credit risk.
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.
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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.
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 chargeoffs to the FI.
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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.
PDA = 0.105(0.65) - 0.35(0.05) = 0.05075 or 5.0755%
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, B’s higher debt-asset ratio increases the firm’s probability of default to be higher than firm
A’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 = 0.10 is the
borrower’s profit ratio. 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.
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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
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 long-term debt 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.
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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 90
Inventory 90 Accruals 30
Long-term debt 150
Plant and equipment 500 Equity (ret. earnings = $22) 400
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.
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 – 90 – 30) / 700 = 0.0714 X1 = Working capital/total assets (TA)

X2 = (22) / 700 = 0.0314 X2 = Retained earnings/TA
X3 = (500 – 360) / 700 = 0.20 X3 = EBIT/TA
X4 = 400 / 150 = 2.6667 X4 = Market value of equity/Book value of long-term debt
X5 = 500 / 700 = 0.7143 X5 = Sales/TA
Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(0.20) + 0.6(2.6667) + 1.0(0.7143) = 3.104

= 0.0857 + 0.0440 + 0.6600 + 1.600 + 0.7143 = 3.104
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 3.104 is greater than 2.99, ABC Inc.’s application for a capital expansion
loan should be approved.
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c. If sales for MNO were $300,000, 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 - 90 - 30) / 700 = 0.0714

X2 = 22 / 700 = 0.0314
X3 = -60 / 700 = -0.0857
X4 = 200 / 150 = 1.3333
X5 = 300 / 700 = 0.4286
Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(-0.0857) + 0.6(1.3333) + 1.0(0.4286) = 1.0754
Since ABC's Z-score falls to 1.0754 < 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
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. tFor 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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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) = 0.968, or 96.80 percent
=> probability of default = 1 – 0.968 = 0.032, 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 3.20 percent on a 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 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%
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. Solve for the probability of repayment (p):
1+ i
−  1.055 − 0.5
1+ k
p= = 1.085 = 0.9447 or 94.47 percent
1−  1 − 0.5
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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 − 0.9447
1+ k
p= = 1.085 = 0.5000 or 50.00 percent
1−  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.
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 (p) 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.
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%
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There is an 11.65 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%
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
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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.
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  f = 8.933%
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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%
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%
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Note: The annual survival rate is pt = 1 – annual default rate, and the cumulative default rate for
n = 3 of mortgages is 1 – (p1 x p2 x p3 x p4)
= 1 – (1 – 0.001) x (1 - 0.0025) x (1 - 0.006) = 1 - (0.999 x 0.9975 x 0.9940) = 0.0164 = 1.64%
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) 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.
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

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

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
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 BalanceDefault 1 - An. Def. Default Rate Default Rate
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%
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%
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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.
C-rated Bonds Test with 10x default.

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.
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. 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 R
RAROC = where LN = − DLN x LN x where R is the change in yield spread.
Loan risk (or LN ) 1+ R
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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
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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 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) = 60%
Standard deviation of the rate of change in the value of the underlying assets = 15%
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Substituting these values into the equations for h1 and h2 and solving for the areas under the
standardized normal distribution, we find that:
d = Be-iτ /A = (0.60)e-0.04(4) = 0.5113 or 51.13 percent.
h1 = -[0.5 x (0.15)2 x 4 - ln(0.5113)]/(0.15)(4)1/2 = -2.3861

h2 = -[0.5 x (0.15)2 x 4 + ln(0.5113)]/(0.15)(4)1/2 = 2.0861
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(h2) + N(h1)1/d ]

= $500,000 e-0.04(4) [N(2.0861) + N(-2.3861) x 1.6667]
= $426,071.89[0.9815 + 0.00853 x 1.6667] = $424,232.62
The risk premium, ϕ = k(τ) – i = (-1/τ) ln[N(h2) + (1/d)N(h1)]

= (-1/4)ln[0.9815 + 0.00853 x 1.6667] = 0.001085 = 0.10815%
Thus, the risky loan rate k(τ) should be set at 4.1082 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
Current market value of loan = l(τ) = Be-iτ [N(h1)1/d + N(h2)]
= $184,623.27[N(-1.8578) x 1.62493 + N(1.5750)]
= $184,623.27[1.62493 x 0.031654 + 0.94265] = $183,531
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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 debts 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
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
Current market value of loan = l(τ) = Be-iτ [N(h1)1/d + N(h2)]
= $4,852,227.67[N(-2.6722) x 1.25 + N(2.5873)]
= $4,852,227.67 [1.25 x 0.003778 + 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%.
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Education.
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.
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
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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
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.
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Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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 large businesses?
Besides the obvious difference in the sizes of the borrowers, for a large business there is also a
more well defined corporate structure and a clearer delineation of the corporate assets from the
personal assets of the owners. 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?
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.
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Education.
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?
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Education.
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/550m) + 1.0(1250m/1470m) = 0.1510 + 0.1905 + 0.7184
+ 1.764 + 0.8503 = 3.674 > 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, 9%, the bank should make the loan.
The bank should accept all four of the loans.
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Education.
Solution for End-of-Chapter Questions and Problems: Chapter Eleven
1. How do loan portfolio risks differ from individual loan risks?
Loan portfolio risks refer to the risks of a portfolio of loans as opposed to the risks of a single
loan. Inherent in the distinction is the elimination of some of the borrower-specific risks of
individual loans because of benefits from diversification.
2. What is migration analysis? How do FIs use it to measure credit risk concentration? What
are its shortcomings?
Migration analysis uses information from the market to determine the credit risk of an individual
loan or sectoral loans. With this method, FI managers track credit ratings, such as S&P and
Moody’s ratings, of firms in particular sectors or ratings classes for unusual declines to
determine whether firms in a particular sector are experiencing repayment problems. This
information can be used to either curtail lending in that sector or to reduce maturity and/or
increase interest rates. A problem with migration analysis is that the information may be too late,
because ratings agencies usually downgrade issues only after the firm or industry has
experienced a downturn.
3. What does loan concentration risk mean?
Loan concentration risk refers to the extra risk borne by having too many loans concentrated
with one firm, industry, or economic sector. To the extent that a portfolio of loans represents
loans made to a diverse cross section of the economy, concentration risk is minimized.
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?
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.08 =
62.5 percent of capital is the maximum amount that can be lent to firms in the automobile sector.
b. If the average historical losses in the mining sector total 15 percent, what is the
maximum loan a manager can lend to firms in this sector as a percentage of total
capital?
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.15 =
33.3 percent of capital is the maximum amount that can be lent to firms in the mining sector.
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Education.
5. An FI has set a maximum loss of 2 percent of total capital as a basis for setting
concentration limits on loans to individual firms. If it has set a concentration limit of 25
percent to a firm, what is the expected loss rate for that firm?
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate)

25 percent = 2 percent x 1/Loss rate => Loss rate = 0.02/0.25 = 8 percent
6. Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s
portfolio.
The fundamental lesson of modern portfolio theory is that, to the extent that an FI manager holds
widely traded loans and bonds as assets, or can calculate loan or bond returns, portfolio
diversification models can be used to measure and control the FI’s aggregate credit risk
exposure. By taking advantage of its size, an FI can diversify considerable amounts of credit risk
as long as the returns on different assets are imperfectly correlated with respect to their default
risk adjusted returns. By fully exploiting diversification potential with bonds or loans whose
returns are negatively correlated or that have a low positive correlations with those in the
existing portfolio, the FI manager can produce a set of efficient frontier portfolios, defined as
those portfolios that provide the maximum returns for a given level of risk or the lowest risk for a
given level of returns. By choosing portfolios on the efficient frontier, an FI manager may be
able to reduce credit risk to the fullest extent. As shown in Figure 11-1, a manager’s selection of
a particular portfolio on the efficient frontier is determined by the risk-return trade-off.
7. Suppose that an FI holds two loans with the following characteristics:
Loan i Xi Ri σi σi 2 .
1 0.55 8% 8.55% 73.1025% ρ12 = 0.24
2 0.45 10 9.15 83.7225 σ12 = 18.7758
Calculate the return and risk of the portfolio.
The return on the loan portfolio is:
Rp = 0.55 (8%) + 0.45 (10%) = 8.90%
The risk of the portfolio is:
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Education.
σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (18.7758%) = 48.36133%
or σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (0.24)(8.55%)(9.15%) =
48.36133%
and σp = √ 48.36133% = 6.95%
Notice that the risk (or standard deviation of returns) of the portfolio, σp (6.95 percent), is less
than the risk of either individual asset (8.55 percent and 9.15 percent, respectively). The low
correlation of the returns of the two loans (0.24) results in an overall reduction of risk when they
are put together in an FI's portfolio.
8. The Bank of Tinytown has two $20,000 loans that have the following characteristics. Loan
A has an expected return of 10 percent and a standard deviation of returns of 10 percent.
The expected return and standard deviation of returns for loan B are 12 percent and 20
percent, respectively.
a. If the correlation coefficient between loans A and B is 0.15, what are the expected return and
standard deviation of this portfolio?
XA = XB = $20,000/$40,000 = 0.5
Expected return = 0.5(10%) + 0.5(12%) = 11 percent
Standard deviation = [0.52(0.10)2 + 0.52(0.20)2 + 2(0.5)(0.5)(0.10)(0.20)(.15)]½ = 11.83%
b. What is the standard deviation of the portfolio if the correlation is -0.15?
Standard deviation = [0.52(0.10)2 + 0.52(0.20)2 + 2(0.5)(0.5)(0.10)(0.20)(-0.15)]½ = 10.49%
c. What role does the covariance, or correlation, play in the risk reduction attributes of modern
portfolio theory?
The risk of the portfolio as measured by the standard deviation is reduced when the covariance is
reduced. If the correlation is less than +1.0, the standard deviation of the portfolio will always be
less than the weighted average of the standard deviations of the individual assets.
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Education.
9. Why is it difficult for small banks and thrifts to measure credit risk using modern portfolio
theory?
The basic premise behind modern portfolio theory is the ability to diversify and reduce risk by
eliminating diversifiable risk. Small banks and thrifts may not have the ability to diversify their
asset base, especially if the local markets which they serve have a limited number of industries.
The ability to diversify is even more acute if these loans cannot be traded easily.
10. What is the minimum risk portfolio? Why is this portfolio usually not the portfolio chosen
by FIs to optimize the return-risk tradeoff?
The minimum risk portfolio is the combination of assets that reduces portfolio risk as measured
by the standard deviation of returns to the lowest possible level. This portfolio usually is not the
optimal portfolio choice because the returns on this portfolio are low relative to other alternative
portfolio selections. By accepting some additional risk, portfolio managers are able to realize a
higher level of return relative to the risk of the portfolio.
11. The obvious benefit to holding a diversified portfolio of loans is to spread risk exposures so
that a single event does not result in a great loss to an FI. Are there any benefits to not
being diversified?
One benefit to not being diversified is that an FI that lends to a certain industrial or geographic
sector is likely to gain expertise about that sector. Being diversified requires that the FI becomes
familiar with many more areas of business. This may not always be possible, particularly for
small FIs.
12. A bank vice president is attempting to rank, in terms of the risk-reward trade-off, the loan
portfolios of three loan officers. Information on the portfolios is noted below. How would
you rank the three portfolios?
Expected Standard
Portfolio Return Deviation
A 10% 8%
B 12% 9%
C 11% 10%
Portfolio B dominates portfolio C because B has a higher expected return and a lower standard
deviation. Thus, C is clearly inferior. A comparison of portfolios A and B represents a risk-return
trade-off in that B has a higher expected return, but B also has higher risk. A crude comparison
may use the coefficient of variation or the Sharpe measure, but a judgment regarding which
portfolio is “better” would be based on the risk preference of the vice president.
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Education.
13. Suppose that an FI holds two loans with the following characteristics.
Annual
Spread between Loss to FI Expected
Loan Rate and FI’s Annual Given Default
Loan Xi Cost of Funds Fees Default Frequency
1 0.45 5.5% 2.25% 30% 3.5% ρ12 = -0.15
2 0.55 3.5 1.75 20 1.0
Calculate of the return and risk on the two-asset portfolio using Moody’s Analytics
Portfolio Manager.
The return and risk on loan 1 are:

R1 = (0.055 + 0.0225) - [0.035 x 0.30] = 0.0670 or 6.70%
σ1 = [0.035 x (1 - 0.035)]1/2 x 0.30 = 0.05513 or 5.513%
The return and risk on loan 2 are:

R2 = (0.035 + 0.0175) - [0.01 x 0.20] = 0.0505 or 5.05%
σ2 = [0.01 x (1 - 0.01)]1/2 x 0.20 = 0.01990 or 1.990%
The return and risk of the portfolio is then:
Rp = 0.45 (6.70%) + 0.55 (5.05%) = 5.7925%
σp2 = (0.45)2 (5.513%)2 + (0.55)2 (1.990%)2 + 2 (0.45) (0.55)(-0.15)(5.513%)(1.990%) = 6.53876%
and, σp = (6.53876%)1/2 = 2.56%
14. CountrySide Bank uses the Moody’s Analytics Portfolio Manager model to evaluate the
risk-return characteristics of the loans in its portfolio. A specific $10 million loan earns 2
percent per year in fees and the loan is priced at a 4 percent spread over the cost of funds
for the bank. Because of collateral considerations, the loss to the bank if the borrower
defaults will be 20 percent of the loan’s face value. The expected probability of default is 3
percent. What is the anticipated return on this loan? What is the risk of the loan?
Expected return = AISi – E(Li) = (0.02 + 0.04) – (0.03 x 0.20) = 0.054 or 5.4 percent
Risk of the loan = Di x LGDi = [0.03(0.97)]½ x 0.20 = 0.0341 or 3.41 percent
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Education.
15. Suppose that an FI holds two loans with the following characteristics.
Annual
Spread between Loss to FI Expected
Loan Rate and FI’s Annual Given Default
Loan Xi Cost of Funds Fees Default Frequency
1 ? 4.0% 1.50% ?% 4.0% ρ12 = -0.10
2 ? 2.5 1.15 ? 1.5
The return on loan 1 is R1 = 6.25%, the risk on loan 2 is σ2 = 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, σp, using
Moody’s Analytics Portfolio Manager.
R1 = 0.0625 = (0.04 + 0.015) - [0.040 x LGD1] => LGD1 = (0.0625 – (0.04 + 0.015))/(-0.04) = 0.1875
=> σ1 = [0.04(1 - 0.04)]1/2 x 0.1875 = 0.03674 or 3.674%
σ2 = 0.018233 = [(0.015(1 - 0.015)]1/2 x LGD2 => LGD2 = 0.018233/[(0.015(1 - 0.015)]1/2 = 0.15
=> R2 = (0.025 + 0.0115) - [0.015 x 0.15] = 0.03425 or 3.425%
=> Rp = X1 (0.0625) + (1 – X1) (0.03425) = 0.04555
=> X1 = (0.04555 - 0.03425)/(0.0625 - 0.03425) = 0.40 and X2 = 1 - 0.40 = 0.60
σp2 = (0.40)2 (0.03674)2 + (0.60)2 (0.018233)2 + 2 (0.40)(0.60)(-0.10)(0.03674)(0.018233) = 0.000303523

Thus, σp = (0.000303523)1/2 = 0.0174 = 1.74%.
16. What databases are available that contain loan information at national and regional levels?
How can they be used to analyze credit concentration risk?
Two publicly available databases are (a) the commercial bank Call Reports of the Federal
Reserve Board which contain various information supplied by banks quarterly and (b) the Shared
National Credit database, which provides information on loan volumes of FIs separated by two-
digit SIC (Standard Industrial Classification) codes. Such data can be used as a benchmark to
determine whether an FI’s asset allocation is significantly different from the national or regional
average.
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Education.
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?
Using Xs to represent portfolio holdings:

Bank A Bank B
(X1j - X1 )2 (0.50 - 0.30)2 = 0.0400 (0.10 - 0.30)2 = 0.0400
(X2j - X2 )2 (0.30 - 0.40)2 = 0.0100 (0.40 - 0.40)2 = 0.0000
(X3j - X3 )2 (0.20 - 0.30)2 = 0.0100 (0.50 - 0.30)2 = 0.0400
n n =3 n =3
i −1
( X ij −X i ) 2  = 0.0600
i =1
 = 0.0800
i =1
n
 (X ij − X i )2
= i =1
A = 14.14 percent B = 16.33 percent
n
Bank B deviates from the national average more than Bank A.
b. Is a large standard deviation necessarily bad for an FI using this model?
No, a higher standard deviation is not necessarily bad for an FI because the FI could have
comparative advantages that are not required or available to a national well-diversified bank. For
example, an FI could generate high returns by serving specialized markets or product niches that
are not well diversified. Further, an FI could specialize in only one product, such as mortgages,
but be well-diversified within this product line by investing in several different types of
mortgages that are distributed both nationally and internationally. This would still enable it to
obtain portfolio diversification benefits that are similar to the national average.
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Education.
18. Assume that, on average, national banks engaged primarily in mortgage lending have their
assets diversified in the following proportions: 60 percent residential, 15 percent
commercial, 5 percent international, and 20 percent mortgage-backed securities. A local
bank has the following distribution of mortgage loans: 50 percent residential, 30 percent
commercial, and 20 percent international. How does the local bank differ from national
banks?

(X1j - X1 )2 (0.50 - 0.60)2 = 0.0100
(X2j - X2 )2 (0.30 - 0.15)2 = 0.0225
(X3j - X3 )2 (0.20 - 0.05)2 = 0.0225
(X4j - X4 )2 (0.00 - 0.20)2 = 0.0400
n n =4
i =1
( X ij −X i ) 2  = 0.0950
i =1
n
 (X ij − X i )2
= i =1
 = 15.41 percent
n
The bank’s standard deviation in its loan portfolio allocation is 15.41 percent. This suggests that
the bank is different from the national average. Whether it is significantly different cannot be
stated without comparing it to other banks.
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
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Education.
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, Xh = loss rate in the consumer (household)
sector, XL = loss rate for its total loan portfolio.
a. If the bank’s total loan loss rates increase by 10 percent, what are the expected loss rate increases
in the commercial and consumer sectors?
Commercial loan loss rates will increase by 0.002 + 0.8(0.10) = 8.20 percent.
Consumer loan loss rates will increase by 0.003 + 1.8(0.10) = 18.30 percent.
b. In which sector should the bank limit its loans and why?
The bank should limit its loans to the consumer sector because the loss rates are systematically
higher than the loss rates for the total loan portfolio. Loss rates are lower for the commercial
sector. For a 10 percent increase in the total loan portfolio, the consumer loss rate is expected to
increase by 18.30 percent, as opposed to only 8.2 percent for the commercial sector.
20. What reasons did the Federal Reserve Board offer for recommending the use of subjective
evaluations of credit concentration risk instead of quantitative models? How did this
change in 2006?
The Federal Reserve Board recommended a subjective evaluation of credit concentration risk
instead of quantitative models because (a) current methods to identify credit concentrations were
not reliable and (b) there was insufficient data to develop reliable quantitative models. This
change in June 2006 as the Bank for International Settlements released guidance on sound credit
risk assessment and valuation for loans. The guidance addresses how common data and
processes related to loans may be used for assessing credit risk, accounting for loan impairment
and determining regulatory capital requirements and is structured around ten principles that fall
within two broad categories: i) supervisory expectations concerning sound credit risk assessment
and valuation for loans and ii) supervisory evaluation of credit risk assessment for loans, controls
and capital adequacy.
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Education.
21. What rules on credit concentrations has the National Association of Insurance
Commissioners enacted? How are they related to modern portfolio theory?
The NAIC set a maximum limit of 3% that life insurers can hold in securities belonging to a
single issuer. Similarly, the limit is 5% for property-casualty (PC) insurers. This forces life
insurers to hold a minimum of 33 different securities and PC insurers to hold a minimum of 20
different securities. Modern portfolio theory shows that by holding well-diversified portfolios,
investors can eliminate undiversifiable risk and be subject only to market risk. This enables
investors to hold portfolios that provide either high returns for a given level of risk or low risks
for a given level of returns.
22. An FI is limited to holding no more than 8 percent of its assets in securities of a single
issuer. What is the minimum number of securities it should hold to meet this requirement?
What if the requirements are 2 percent, 4 percent, and 7 percent?
If an FI is limited to holding a maximum of 8 percent of securities of a single issuer, it will be

forced to hold 100/8 = 12.5, or 13 different securities.
For 2%, it will be 100/2, or 50 different securities.

The questions and problems that follow refer to Appendixes 11A and 11B. Refer to the information
in Appendix 11A for problems 23 through 25. Refer to Appendix 11B for problem 26.
23. 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% = 6.59%.
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-risk spread 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.
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Education.
c. Why does the probability distribution of possible loan values have a negative skew?
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 a fixed percentage of the risk-weighted
book value of the loan (e.g., 8 percent). 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 the risk-weighted book value because of the non-normality
of the probability distributions.
24 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% ϕt% .
AAA 0.01% $114.82m 1 3.00% 0.72%
AA 0.31 114.60m 2 3.40 0.96
A 1.45 114.03m 3 3.75 1.16
BBB 6.05 4 4.00 1.30
BB 85.48 108.55m
B 5.60 98.43m
CCC 0.90 86.82m
Default 0.20 54.12m
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?
$7m $7m $7m $107m

PV = $7m + + 2
+ + = $113.27 million
1.0372 (1.0436) (1.0491) (1.0530) 4
3
b. What is the mean (expected) value of the loan at the end of year 1?
The solution table on the following page reveals a value of $108.06 million.
c. What is the volatility of the loan value at the end of year 1?
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Education.
The volatility or standard deviation of the loan value is $4.19 million.
d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal
distribution of values.
The 5 percent VAR is 1.65 x $4.19m = $6.91m.

The 1 percent VAR is 2.33 x $4.19m = $9.76m.
Probability
Year-end Value Probability x Deviation
Rating Probability (m of $) x 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 = $108.06m Variance = 17.5740
Standard Deviation = $4.19m
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 = $108.06m - $98.43m = $9.63m

1% VAR = 99% of actual distribution = $108.06m - $86.82m = $21.24m
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, $19.31m = (1 – 0.1/1.1) x $21.24m.
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 (2.33 x
$4.19m) in capital under the normal distribution assumption. In each case, the amounts exceed
the Fed/BIS amount.
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Education.
25. How does the Credit Risk+ model of Credit Suisse Financial Products differ from the
CreditMetrics model of J.P. Morgan Chase?
CreditRisk+ 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
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 focuses on
estimating a complete VAR framework.
26. An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have a historical
average default rate of 4 percent and the severity of loss is 40 cents per dollar.
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 0.018316x16
Pr obability of 2 defaults = = = = 0.1465 = 14.65%
n! 1x 2 2
n 2 3 4 5 8 .
Probability 14.65% 19.54% 19.54% 15.63% 2.98%
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 0.00529 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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Integrated Mini Case: Loan Portfolio Analysis
As a senior loan officer at MC Financial Corp, you have a loan application from a firm in the
biotech industry. While the loan has been approved on the basis of an individual loan, you must
evaluate the loan based on its impact on the risk of the overall loan portfolio. The FI uses the
following three methods to assess its loan portfolio risk.
1. Concentration Limits - The FI currently has lent an amount equal to 40 percent of its capital
to the biotech industry and does not lend to a firm in any sector that generates losses in excess
of 2 percent of capital. The average historical losses in the biotech industry total 5 percent.
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = .02 x

1/0.05 = 40 percent of capital is the maximum amount that can be lent to firms in the
biotech sector.
MC Financial already has 40 percent of its capital lent out to the biotech industry. To give out
this new loan would put the FI over its concentration limit. Thus, MC Financial should not grant
this loan.
2. Loan Volume-based Model - National and MC Financial’s loan portfolio allocations are as
follows.
Sectors National MC Financial
Commercial 30% 40%
Real Estate 50% 45%
Consumer 20% 15%
MC Financial does not want to deviate from the national average by more than 12.25 percent.

(X1j - X1 )2 (0.40 - 0.30)2 = 0.0100
(X2j - X2 )2 (0.45 - 0.50)2 = 0.0025
(X3j - X3 )2 (0.15 - 0.20)2 = 0.0025
n n =3
i =1
( X ij −X i ) 2  = 0.0150
i =1
n
 (X ij − X i )2
= i =1
 = 12.25 percent
n
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Education.
The FI’s standard deviation in its loan portfolio allocation is 12.25 percent. To issue
another C&I loan would push MC Financial even further from the national average. Thus,
the FI would not want to give out the loan
3. Loan Loss Ratio-based Model - Based on regression analysis on historical loan losses, the FI
estimates the following loan loss ratio models:
XC&I = 0.001 + 0.85XL and Xcon = 0.003 + 0.65XL
where XC&I = loss rate in the commercial sector, Xcon = loss rate in the consumer
(household) sector, XL = loss rate for its total loan portfolio.
MC Financial’s total increase in the loan loss ratio is expected to be 12 percent next year.
Commercial loan loss rates will increase by 0.001 + 0.85(0.12) = 10.30 percent.
Consumer loan loss rates will increase by 0.003 + .65(0.12) = 8.10 percent.
MC Financial should limit its loans to the commercial sector because the loss rates are
systematically higher than the loss rates for the total loan portfolio. Loss rates are lower for the
consumer sector. For a 12 percent increase in the total losses in the loan portfolio, the
commercial loss rate is expected to increase by 10.30 percent, as opposed to only 8.1 percent for
the consumer sector. Thus, MC Financial should not issue this loan.
Should MC Financial Corp. grant this loan?
Based on all three models, from an overall loan portfolio perspective, MC Financial would not
want to issue this loan to a firm in the biotech sector.
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Education.
Additional Example for Chapter 12

Sectors National Bank A Bank B
Commercial 20% 50% 30%

Consumer 40% 20% 40%
Real Estate 40% 30% 30%
How different are Banks A and B from the national benchmark? When using this example, note
that there is an implied assumption that Bank A and B belong to a certain size class or have some
common denominator linking them to the national benchmark. If that is the case, then the
solution is to estimate the standard deviation.
We use Xs to represent the portfolio concentrations. X1, X2 and X3 are the national benchmark
percentages
Bank A Bank B
(X1j - X1 )2 (50 - 20)2 = 900 (30 - 20)2 = 100
(X2j - X2 )2 (20 - 40)2 = 400 (40 - 40)2 = 0
(X3j - X3 )2 (30 - 40)2 = 100 (30 - 40)2 = 100
n n =3 n =3

i =1
( X ij −X i ) 2  =1,400
i =1
 = 200
i =1
n
 (X ij − X i )2
= i =1
 = 37.42 percent  = 14.14 percent
n
Thus we can see here that Bank A is significantly different from the national benchmark
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Education.
Solutions for End-of-Chapter Questions and Problems: Chapter Twenty-Two
1. What are derivative contracts? What is the value of derivative contracts to the managers of
FIs? Which type of derivative contracts had the highest notional value outstanding among
all U.S. banks as of June 2012?
Derivatives are financial assets whose value is determined by the value of some underlying asset.
As such, derivative contracts are instruments that provide the opportunity to take some action at
a later date based on an agreement to do so at the current time. Although the contracts differ, the
price, timing, and extent of the later actions are usually agreed upon at the time the contracts are
arranged. Normally, the contract values depend on the activity of the underlying asset.
Derivative contracts have value to managers of FIs because of their ability to help in managing
the various types of risk prevalent in the institutions. As of June 2012 the largest category of
derivatives in use by commercial banks was swaps, followed by futures and forwards, and then
options.
2. What are some of the major differences between futures and forward contracts? How do
these contracts differ from spot contracts?
A spot contract is an exchange of cash, or immediate payment, for financial assets, or any other
type of assets, at the time the agreement to transact business is made, i.e., at time 0. Futures and
forward contracts both are agreements between a buyer and a seller at time 0 to exchange the
asset for cash (or some other type of payment) at a later time in the future. The specific grade and
quantity of asset is identified at time 0, as is the specific price paid and time the transaction will
eventually occur.
One of the differences between futures and forward contracts is the uniqueness of forward
contracts because they are negotiated between two parties. On the other hand, futures contracts
are standardized because they are offered by and traded on an exchange. Futures contracts are
marked to market daily by the exchange and the exchange guarantees the performance of the
contract to both parties. Thus, the risk of default by either party is minimized from the viewpoint
of the other party. No such guarantee exists for a forward contract. Finally, delivery of the asset
almost always occurs for forward contracts, but seldom occurs for futures contracts. Instead, an
offsetting or reverse transaction occurs through the exchange prior to the maturity of the
contract.
3. What is a naive hedge? How does a naive hedge protect an FI from risk?
A hedge involves protecting the price of or return on an asset from adverse changes in price or
return in the market. A naive hedge usually involves the use of a derivative instrument that has
the same underlying asset as the asset being hedged. Thus, if a change in the price of the cash
asset results in a gain, the same change in market value will cause the derivative instrument to
generate a loss that offsets the gain in the cash asset.
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Education.
4. An FI holds a 15-year, $10 million par value bond that is priced at 104 with a yield to
maturity of 7 percent. The bond has a duration of eight years, and the FI plans to sell it after
two months. The FI’s market analyst predicts that interest rates will be 8 percent at the time
of the desired sale. Because most other analysts are predicting no change in rates, two-
month forward contracts for 15-year bonds are available at 104. The FI would like to hedge
against the expected change in interest rates with an appropriate position in a forward
contract. What will this position be? Show that if rates rise 1 percent as forecast, the hedge
will protect the FI from loss.
The expected change in the spot position is –8 x $10,400,000 x (0.01/1.07) = -$777,570. This
would mean a price change from 104 to 96.2243 per $100 face value of bonds. By entering into a
two-month forward contract to sell $10,000,000 of 15-year bonds at 104, the FI will have hedged
its spot position. If rates rise by 1 percent, and the bond value falls by $777,570, the FI can close
out its forward position by receiving 104 for bonds that are now worth 96.2243 per $100 face
value. The profit on the forward position will offset the loss in the spot market.
The actual transaction to close the forward contract may involve buying the bonds in the market
at 96.2243 and selling the bonds to the counterparty at 104 under the terms of the forward
contract. Note that if a futures contract were used, closing the hedge position would involve
buying a futures contract through the exchange with the same maturity date and dollar amount as
the initial opening hedge contract.
5. Contrast the position of being short with that of being long in futures contracts.
To be short in futures contracts means that you have agreed to sell the underlying asset at a
future time, while being long means that you have agreed to buy the asset at a later time. In each
case, the price and the time of the future transaction are agreed upon when the contracts are
initially negotiated.
6. Suppose an FI purchases a Treasury bond futures contract at 95.
a. What is the FI’s obligation at the time the futures contract is purchased?
The FI is obligated to take delivery of a $100,000 face value 20-year Treasury bond at a price of $95,000 at some
predetermined later date.
b. If an FI purchases this contract, in what kind of hedge is it engaged?
This is a long hedge undertaken to protect the FI from falling interest rates.
c. Assume that the Treasury bond futures price falls to 94. What is the loss or gain?
The FI will lose $1,000 since the FI must pay $95,000 for bonds that have a market value of only $94,000.
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Education.
d. Assume that the Treasury bond futures price rises to 97. Mark-to-market the position.
In this case the FI gains $2,000 since the FI pays only $95,000 for bonds that have a market value of $97,000.
7. Long Bank has assets that consist mostly of 30-year mortgages and liabilities that are short-term demand and
time deposits. Will an interest rate futures contract the bank buys add to or subtract from the bank’s risk?
The purchase of an interest rate futures contract will add to the risk of the bank. If rates increase in the market, the
value of the bank’s assets will decrease more than the value of the liabilities. In addition, the value of the futures
contract also will decrease. Thus, the bank will suffer decreases in value both on and off the balance sheet. If the
bank had sold the futures contract, the increase in rates would have resulted in the futures position producing a gain
that would offset (at least partially) the loss in value on the balance sheet.
8. In each of the following cases, indicate whether it would be appropriate for an FI to buy or
sell a forward contract to hedge the appropriate risk.
a. A commercial bank plans to issue CDs in three months.
The bank should sell a forward contract to protect against an increase in interest rates.
b. An insurance company plans to buy bonds in two months.
The insurance company should buy a forward contract to protect against a decrease in interest
rates.
c. A savings bank is going to sell Treasury securities it holds in its investment portfolio
next month.
The savings bank should sell a forward contract to protect against an increase in interest rates.
d. A U.S. bank lends to a French company. The loan is payable in euros.
The bank should sell euros forward to protect against a decrease in the value of the euro, or an
increase in the value of the dollar.
e. A finance company has assets with a duration of six years and liabilities with a duration
of 13 years.
The finance company should buy a forward contract to protect against decreasing interest rates that would cause the
value of liabilities to increase more than the value of assets, thus causing a decrease in equity value.
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Education.
9. The duration of a 20-year, 8 percent coupon Treasury bond selling at par is 10.292 years.
The bond’s interest is paid semiannually, and the bond qualifies for delivery against the
Treasury bond futures contract.
a. What is the modified duration of this bond?
The modified duration is 10.292/1.04 = 9.896 years.
b. What is the impact on the Treasury bond price if market interest rates increase 50 basis
points?
P = -MD(R)$100,000 = -9.896 x 0.005 x $100,000 = -$4,948.08.
c. If you sold a Treasury bond futures contract at 95 and interest rates rose 50 basis points,
what would be the change in the value of your futures position?
P = - MD(R) P = - 9.896(0.005)$95,000 = - $4,700.67
d. If you purchased the bond at par and sold the futures contract, what would be the net
value of your hedge after the increase in interest rates?
Decrease in market value of the bond purchase -$4,948.08

Gain in value from the sale of futures contract $4,700.67
Net gain or loss from hedge -$247.41
10. What are the differences between a microhedge and a macrohedge for a FI? Why is it generally more efficient
for FIs to employ a macrohedge than a series of microhedges?
A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk
exposure of a specific transaction, while a macrohedge is a hedge of the duration gap of the
entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance
sheet position will find that hedging is excessively costly, because the use of a series of
microhedges ignores the FI’s internal hedges that are already on the balance sheet. That is, if a
long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching
long-term fixed-rate liability position that also is exposed to interest rate decreases. Putting on
two microhedges to reduce the risk exposures of each of these positions fails to recognize that
the FI has already hedged much of its risk by taking matched balance sheet positions. The
efficiency of the macrohedge is that it focuses only on those mismatched positions that are
candidates for off-balance-sheet hedging activities.
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Education.
11. What are the reasons why an FI may choose to hedge selectively its portfolio?
Selective hedging involves an explicit attempt to not minimize the risk on the balance sheet. An
FI may choose to hedge selectively in an attempt to improve profit performance by accepting
some risk on the balance sheet, or to arbitrage profits between a spot asset’s price movements
and the price movements of the futures price. This latter situation often occurs because of
differential changes in interest rates caused in part by cross-hedging.
12. Hedge Row Bank has the following balance sheet (in millions):
Assets $150 Liabilities $135

Equity 15
Total $150 Total $150
The duration of the assets is six years and the duration of the liabilities is four years. The bank is expecting
interest rates to fall from 10 percent to 9 percent over the next year.
a. What is the duration gap for Hedge Row Bank?
DGAP = DA – k DL = 6 – (0.9)(4) = 6 – 3.6 = 2.4 years
b. What is the expected change in net worth for Hedge Row Bank if the forecast is
accurate?
Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.01/1.10)$150m = $3.272 million
c. What will be the effect on net worth if interest rates increase 110 basis points?
Expected E = -DGAP[R/(1 + R)]A = -2.4(0.011/1.10)$150 = -$3.6 million.
d. If the existing interest rate on the liabilities is 6 percent, what will be the effect on net
worth of a 1 percent increase in interest rates?
Solving for the impact on the change in equity under this assumption involves finding the impact of the change in
interest rates on each side of the balance sheet, and then determining the difference in these values. The analysis is
based on the equation:
Expected E = A - L
A = -DA[RA/(1 + RA)]A = -6[0.01/1.10]$150m = -$8.1818 million
and L = -DL[RL/(1 + RL)]L = -4[0.01/1.06]$135m = -$5.0943 million
Therefore, E = A - L = -$8.1818m – (-$5.0943m) = - $3.0875 million
13. For a given change in interest rates, why is the sensitivity of the price of a Treasury bond futures contract
greater than the sensitivity of the price of a Treasury bill futures contract?
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Education.
The price sensitivity of a futures contract depends on the duration of the asset underlying the
contract. In the case of a T-bill contract, the duration is 0.25 years. In the case of a T-bond
contract, the duration is much longer.
14. What is the meaning of the Treasury bond futures price quote 101-130?
A quote of 101 - 130 = $101 13/32 per $100 face value. Since Treasury bond futures contracts
are for $100,000 face value, the quoted price is $101,406.25.
15. What is meant by fully hedging the balance sheet of an FI?
Fully hedging the balance sheet involves using a sufficient number of futures contracts so that
any loss (or gain) of net worth on the balance sheet is just offset by the gain (or loss) from the
off-balance-sheet use of futures contracts for given changes in interest rates.
16. Tree Row Bank has assets of $150 million, liabilities of $135 million, and equity of $15 million. The asset
duration is six years and the duration of the liabilities is four years. Market interest rates are 10 percent.
Tree Row Bank wishes to hedge the balance sheet with Eurodollar futures contracts, which currently have a
price quote of $96 per $100 face value for the benchmark three-month Eurodollar CD underlying the
contract. The current rate on three-month Eurodollar CDs is 4.0 percent and the duration of these contracts
is 0.25 years.
a. Should the bank go short or long on the futures contracts to establish the correct
macrohedge?
The bank should sell futures contracts since an increase in interest rates would cause the value of the equity and the
futures contracts to decrease. But the bank could buy back the futures contracts to realize a gain to offset the
decreased value of the equity.
b. Assuming no basis risk, how many contracts are necessary to fully hedge the bank?
The number of contracts to hedge the bank is:
− (D A − kD L )A − (6 − (0.9)4)$150m
NF = = = − 1,500 contracts
D F x PF 0.25 x 0.96x$1,000,000
c. Verify that the change in the futures position will offset the change in the cash balance
sheet position for a change in market interest rates of plus 100 basis points and minus
50 basis points.
For an increase in rates of 100 basis points, the change in the cash balance sheet position is:
Expected E = -DGAP[R/(1 + R)]A = -2.4(0.01/1.10)$150m = -$3,272,727.27.
Since there is no basis risk, [R/(1 + R)] = [RF/(1 + RF)], and the change in the value of the
$1,000,000 face value futures contract is:
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Education.
R F
F = −D F  N F  PF  = -0.25 x (-1,500) x 0.96 x $1,000,000 x (0.01/1.10)
1+R F
= $3,272,727.27
For a decrease in rates of 50 basis points, the change in the cash balance sheet position is:
Expected E = -DGAP[R/(1 + R)]A = -2.4(-0.005/1.10)$150m = $1,636,363.64.
The change in the value of the futures contract is:
R F
F = −D F  N F  PF  = -0.25 x (-1,500) x 0.96 x $1,000,000 x (-0.005/1.10)
1+R F
= -$1,636,363.64
d. If the bank had hedged with Treasury bond futures contracts that had a market value of
$95 per $100 of face value, a yield of 8.5295 percent, and a duration of 10.3725 years,
how many futures contracts would have been necessary to hedge fully the balance
sheet? Assume no basis risk.
If Treasury bond futures contracts are used, the face value of the contract is $100,000, and the number of contracts
necessary to hedge the bank is:
− (D A − kD L )A − (6 − (0.9)4)$150m − $360,000,000
NF = = = = − 365.338509 contracts
D F x PF 10.3725 x $95,000 $985,387.5
e. What additional issues should be considered by the bank in choosing between

Eurodollar or T-bond futures contracts?
In cases where a large number of Treasury bonds are necessary to hedge the balance sheet with a macrohedge, the FI
may need to consider whether a sufficient number of deliverable Treasury bonds are available. The number of
Eurodollar contracts necessary to hedge the balance sheet is greater than the number of Treasury bonds, the
Eurodollar market is much deeper and the availability of sufficient deliverable securities should be less of a
problem.
17. What is basis risk? What are the sources of basis risk?
Basis risk is the lack of perfect correlation between changes in the yields of the on-balance-sheet
assets or liabilities and changes in interest rates on the futures contracts. The reason for this
difference is that the cash assets and the futures contracts are traded in different markets.
18. How would your answer for part (b) in problem 16 change if the relationship of the price sensitivity of futures
contracts to the price sensitivity of underlying bonds were br = 0.92?
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Education.
− (D A − kD L )A − (6 − (0.9)4)$150m
NF = = = − 1,630.434783 contracts
D F x PF x br 0.25 x 0.96x$1,000,000x 0.92
The number of contracts necessary to hedge the bank would increase to 1,630.434783 contracts.
19. Reconsider Tree Row Bank in problem 16 but assume that the cost rate on the liabilities is 6 percent. On-
balance-sheet rates are expected to increase by 100 basis points. Further, assume there is basis risk such
that rates on three-month Eurodollar CDs are expected to change by 0.10 times the rate change on assets
and liabilities. That is, RF = 0.10 x R.
a. How many contracts are necessary to fully hedge the bank?
In this case, the bank faces different average interest rates on both sides of the balance sheet. Further, the yield on
the Eurodollar CDs underlying the futures contracts is a third interest rate. Thus, the hedge also has the effects of
basis risk. Determining the number of futures contracts necessary to hedge this balance sheet must consider
separately the effect of a change in rates on each side of the balance sheet, and then consider the combined effect on
equity. Estimating the number of contracts can be determined with the modified general equation:
Modified Equation Model:
F + E = 0
F + A − L = 0
RF R  R 
 − DF ( N F xPF ) x = −  − DA x x A −  − DL x x L  =
(1 + RF ) (1 + R A )  (1 + RL ) 
R A RL
− D A x x A − DL x xL 
(1 + R A ) (1 + R A )
NF = =
RF
DF x PF x
(1 + RF )
0.01 0.01
6x x150,000,000 − 4 x x135,000,000
= −( 1.10 1.06 )
0.10 x 0.01
0.25x 0.96 x1,000,000 x
1.04
− ( $8,181,8183.18 − $5,094,339.63 )
=
$230.7692308
− $3,087,478.56
=
$230.7692308
= − 13,379.07376 contracts
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Education.
b. Verify that the change in the futures position will offset the change in the cash balance
sheet position for a change in market interest rates of plus 100 basis points and minus
50 basis points.
For an increase in rates of 100 basis points, E = -[6 x (0.01/1.01) x $150 m – 4 x (0.01/1.06) x $135
m] = -$3,087,478.56.
R F
F = −D F  N F  PF 
1+R F
= -0.25 x (-13,379.07376) x 0.96 x $1,000,000 x (0.10 x 0.01/1.04)
= $3,087,478.56
For a decrease in rates of 50 basis points, E = -[6 x (-0.005/1.10) x $150 m – 4 x (-0.005/1.06)

x $135 m] = = $1,543,739.28.
R F
F = −D F  N F  PF 
1+R F
= -0.25 x (-13,379.07376) x 0.96 x $1,000,000 x (0.10 x (-0.005)/1.04)
= -$1,543,739.28
c. If the bank had hedged with Treasury bond futures contracts that had a market value of $95 per $100 of face
value, a yield to maturity of 8.5295 percent, and a duration of 10.3725 years, how many futures contracts
would have been necessary to fully hedge the balance sheet? Assume there is basis risk such that rates on
T-bonds are expected to change by 0.75 times the rate change on assets and liabilities. That is, RF = 0.75 x
R.
Estimating the number of contracts can be determined with the modified general equation:
Modified Equation Model:
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Education.
F + E = 0
F + A − L = 0
R F R  R 
 − D F ( N F * PF ) * = −  − DA * * A − − D L * * L =
(1 + R F ) (1 + R A )  (1 + R L ) 
R A R L
− D A x xA − D L x xL 
(1 + R A ) (1 + R A )
NF = =
R F
D F xPF x
(1 + R F )
0.01 0.01
6x x150,000,000 − 4x x135,000,000
= −( 1.10 1.06 )
0.75x 0.01
10.3725x 0.95x100,000x
1.085295
− ( $8,181,8183.18 − $5,094,339.63 )
=
6,809.582878
− $3,087,478.56
=
6,809.582878
= − 453.402009 contracts
20. A mutual fund plans to purchase $500,000 of 30-year Treasury bonds in four months. These bonds have a
duration of 12 years and are priced at 96.25 (percent of face value). The mutual fund is concerned about
interest rates changing over the next four months and is considering a hedge with T-bond futures contracts
that mature in six months. The T-bond futures contracts are selling for 98-24 (32nds) and have a duration of
8.5 years.
a. If interest rate changes in the spot market exactly match those in the futures market,
what type of futures position should the mutual fund create?
The mutual fund needs to buy futures contracts, thus entering into a contract to buy Treasury bonds at 98-24 in four
months. The fund manager fears a fall in interest rates (meaning the T-bond’s price will increase) and by buying a
futures contract, the profit from a fall in rates will offset a loss in the spot market from having to pay more for the
securities.
b. How many contracts should be used?
The number of contracts can be determined by using the following equation:

D * P 12 * $481,250
NF = = = 6.88 contracts
D F * PF 8.5 * $98,750
Rounding this up to the nearest whole number is 7.0 contracts.
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Education.
c. If the implied rate on the deliverable bond in the futures market moves 12 percent more
than the change in the discounted spot rate, how many futures contracts should be used
to hedge the portfolio?
In this case the value of br = 1.12, and the number of contracts is 6.88/1.12 = 6.14 contracts. This may be adjusted
downward to 6 contracts.
d. What causes futures contracts to have a different price sensitivity than the assets in the
spot markets?
One reason for the difference in price sensitivity is that the futures contracts and the cash assets are traded in
different markets.
21. Consider the following balance sheet (in millions) for an FI:
Assets Liabilities
Duration = 10 years $950 Duration = 2 years $860
Equity 90
a. What is the FI's duration gap?
The duration gap is 10 - (860/950)(2) = 8.19 years.
b. What is the FI's interest rate risk exposure?
The FI is exposed to interest rate increases. The market value of equity will decrease if interest rates increase.
c. How can the FI use futures and forward contracts to put on a macrohedge?
The FI can hedge its interest rate risk by selling future or forward contracts.
d. What is the impact on the FI's equity value if the relative change in interest rates is an increase of 1
percent? That is, R/(1+R) = 0.01.
E = - 8.19(950,000)(0.01) = -$77,800
e. Suppose that the FI macrohedges using Treasury bond futures that are currently priced
at 96. What is the impact on the FI's futures position if the relative change in all interest
rates is an increase of 1 percent? That is, R/(1+R) = 0.01. Assume that the deliverable
Treasury bond has a duration of nine years.
F = -9(96,000)(0.01) = -$8,640 per futures contract. Since the macrohedge is a short hedge, this
will be a profit of $8,640 per contract.
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Education.
f. If the FI wants to macrohedge, how many Treasury bond futures contracts does it need?
To macrohedge, the Treasury bond futures position should yield a profit equal to the loss in
equity value (for any given increase in interest rates). Thus, the number of futures contracts must
be sufficient to offset the $77,800 loss in equity value. This will necessitate the sale of
$77,800/8,640 = 9.005 contracts. Rounding down, to construct a macrohedge requires the FI to
sell 9 Treasury bond futures contracts.
22. Refer again to problem 21. How does consideration of basis risk change your answers to
problem 21?
In problem 21, we assumed that basis risk did not exist. That allowed us to assert that the
percentage change in interest rates (R/(1+R)) would be the same for both the futures and the
underlying cash positions. If there is basis risk, then (R/(1+R)) is not necessarily equal to
(Rf/(1+Rf)). If the FI wants to fully hedge its interest rate risk exposure in an environment with
basis risk, the required number of futures contracts must reflect the disparity in volatilities
between the futures and cash markets.
a. Compute the number of futures contracts required to construct a macrohedge if

[Rf/(1+Rf) / R/(1+R)] = br = 0.90
− ( D A - k D L ) A − 8.19(950,000)
If br = 0.9, then: N f = = = − 10 contracts
D F P F br (9)(96,000)( 0.90)
b. Explain what is meant by br = 0.90.
br = 0.90 means that the implied rate on the deliverable bond in the futures market moves by 0.9
percent for every 1 percent change in discounted spot rates (R/(1+R)).
c. If br = 0.90, what information does this provide on the number of futures contracts
needed to construct a macrohedge?
If br = 0.9 then the percentage change in cash market rates exceeds the percentage change in
futures market rates. Since futures prices are less sensitive to interest rate shocks than cash
prices, the FI must use more futures contracts to generate sufficient cash flows to offset the cash
flows on its balance sheet position.
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Education.
23. An FI is planning to hedge its $100 million bond instruments with a cross hedge using Eurodollar interest rate
futures. How would the FI estimate
br = [Rf/(1+Rf) / R/(1+R)]
to determine the exact number of Eurodollar futures contracts to hedge?
One way of estimating br (or the ratio of changes in yields of futures to the yields on the
underlying security) involves regressing the changes in bond yields against Eurodollar futures.
The estimated slope of the line br provides the exact number of contracts needed to hedge. Note
that historical estimation of the basis risk is not a guarantee that it will remain the same in the
future.
24. Village Bank has $240 million worth of assets with a duration of 14 years and liabilities worth $210 million
with a duration of 4 years. In the interest of hedging interest rate risk, Village Bank is contemplating a
macrohedge with interest rate T-bond futures contracts now selling for 102-21 (32nds). The T-bond
underlying the futures contract has a duration of nine years. If the spot and futures interest rates move
together, how many futures contracts must Village Bank sell to fully hedge the balance sheet?
− ( D A − kDL ) A − (14 − (0.875)4)$240m

NF = = = − 2728 contracts
DF x PF 9 x $102,656
25. Assume an FI has assets of $250 million and liabilities of $200 million. The duration of the assets is six years
and the duration of the liabilities is three years. The price of the futures contract is $115,000 and its
duration is 5.5 years.
a. What number of futures contracts is needed to construct a perfect hedge if br = 1.10?
− ( D A - k D L )A − [6 − (0.8 x3)]$250,000,000 − $900,000,000

Nf= = = = − 1,293.57 contracts
( D f x P f xbr) 5.5 x$115,000 x1.10 $695,750
b. If Rf/(1+Rf) = 0.0990, what is the expected R/(1+R)?
br = (Rf/(1+Rf))/(R/(1 + R)) => R/(1 + R) = (Rf/(1+Rf))/br = 0.0990/1.10 = 0.09
26. Suppose an FI purchases a $1 million 91-day (360-day year) Eurodollar futures contract trading at 98.50.
a. If the contract is reversed two days later by selling the contract at 98.60, what is the net
profit?
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Profit = (0.9860 - 0.9850) x 91/360 x 1,000,000 = $252.78
b. What is the loss or gain if the price at reversal is 98.40?
Loss = (0.9840 - 0.9850) x 91/360 x 1,000,000 = -$252.78
27. Dudley Hill Bank has the following balance sheet:
Assets (in millions) Liabilities and Equity (in millions)

A $425 L $380
E 45
.
$425 $425
Further, DA = 6 years
DL = 2 years
The bank manager receives information from an economic forecasting unit that interest
rates are expected to rise from 8 to 9 percent over the next six months.
a. Calculate the potential loss to Dudley Hill’s net worth (E) if the forecast of rising rates
proves to be true.
E = −[D A − kD L ]A R so that E = −[6 − 380 ( 2)]425m 0.01 = -$16,574,074

1+R , 425 1.08
The bank could expect to lose $16,574,074 in shareholders’ net worth should the interest rate
forecast be accurate. Since the FI started with a net worth of $45 million, the loss of $16,574,074
is almost 37 percent of its initial net worth position.
b. Suppose the manager of Dudley Hill Bank wants to hedge this interest rate risk with T-
bond futures contracts. The current futures price quote is $122.03125 per $100 of face
value for the benchmark 20-year, and the minimum contract size is $100,000, so PF
equals $122,031.25. The duration of the deliverable bond is 14.5 years. That is, DF =
14.5 years. How many futures contracts will be needed? Should the manager buy or sell
these contracts? Assume no basis risk.
From the equation for NF, we can now solve for the correct number of futures positions to sell
(NF).
[D A − kDL ]A
NF = [6−(380 / 425)2]425m
D F PF NF = = 1,011.611992
14.5122,031.25
Since the bank is exposed to interest rate increases, it should sell these contracts.
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c. Verify that selling T-bond futures contracts will indeed hedge the FI against a sudden
increase in interest rates from 8 to 9 percent, a 1 percent, interest rate shock.
On-Balance-Sheet: As shown above, when interest rates rise by 1 percent, the FI loses
$16,574,074 in net worth (∆E) on the balance sheet:
E = −[6 − 380 ( 2)]425m 0.01 = -$16,574,074
425 1.08
Off-Balance-Sheet: Since there is no basis risk, [R/(1 + R)] = [RF/(1 + RF)], and the change
in the value of the futures position is:
ΔF = −14.5  (−1,011.611992 ) 122,031.25  1.08
0.01
) = $16,574,074
The value of the off-balance-sheet futures position (∆F) falls by $16,574,074 when the
FI sells 1,011.61192 futures contracts in the T-bond futures market. Such a fall in value of the
futures contracts means a positive cash flow to the futures seller as the buyer compensates the
seller for a lower futures price through the marking-to-market process.
d. If the bank had hedged with Eurodollar futures contracts that had a market value of $98
per $100 of face value, how many futures contracts would have been necessary to
hedge fully the balance sheet?
If futures contracts are used, the duration of the underlying asset is 0.25 years, the face value of the contract is
$1,000,000, and the number of contracts necessary to hedge the bank is:
− (D A − kDL )A − (6 − (380 / 425)2)$425m − $1,790,000,000

NF = = = = − 7,306.122449 contracts
D F x PF 0.25x$980,000 $245,000
e. How would your answer for part (b) change if the relationship of the price sensitivity of futures contracts to
the price sensitivity of underlying bonds were br = 1.15?
− (DA − kDL )A − (6 − (0.9)4)$150m

NF = = = − 879.6626015 contracts
DF x PF x br 14.5 x $122,031.25x1.15
The number of contracts necessary to hedge the bank would decrease to 879.6626015 contracts.
f. Verify that selling T-bond futures contracts will indeed hedge the FI against a sudden
increase in interest rates from 8 to 9 percent, a 1 percent, interest rate shock. Assume
the yield on the T-bond underlying the futures contract is 8.45 percent as the bank
enters the hedge, and rates rise by 1.154792 percent.
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On-Balance-Sheet: As shown above, when interest rates rise by 1 percent, the FI loses
$16,574,074 in net worth (∆E) on the balance sheet:
E = −[6 − 380 ( 2)]425m 0.01 = -$16,574,074
425 1.08
Off-Balance-Sheet: When interest rates rise by 1.154792 percent on the T-bond underlying the
futures contract, the change in the value of the futures position is:
ΔF = −14.5  (−879.6626015 ) 122,031.25  0.01154792
1.0845
) = $16,574,079
28. An FI has an asset investment in euros. The FI expects the exchange rate of $/€ to increase by the maturity of
the asset.
a. Is the dollar appreciating or depreciating against the euro?
The dollar is depreciating as it will take more dollars per € in the future.
b. To fully hedge the investment, should the FI buy or sell euro futures contracts?
The FI should buy € futures.
c. If there is perfect correlation between changes in the spot and futures contracts, how
should the FI determine the number of contracts necessary to hedge the investment
fully?
A sufficient number of futures contracts should be purchased so that a profit (loss) on the futures position will just
offset a loss (profit) on the asset portfolio. If there is perfect correlation between the spot and futures prices, the
number of futures contracts can be determined by dividing the value of the foreign currency asset portfolio by the
foreign currency size of each contract. If the spot and futures prices are not perfectly correlated, the value of the
long asset position at maturity must be adjusted by the hedge ratio before dividing by the size of the futures contract.
29. What is meant by tailing the hedge? What factors allow an FI manager to tail the hedge effectively?
Gains from futures contract positions typically are received throughout the life of the hedge from the process of
marking to market the futures position. These gains can be reinvested to generate interest income cash flows that
reduce the number of futures contracts needed to hedge an original cash position. Higher short-term interest rates
and less uncertainty in the pattern of expected cash flows from marking to market the futures position will increase
the effectiveness of this process.
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30. What does the hedge ratio measure? Under what conditions is this ratio valuable in determining the number
of futures contracts necessary to hedge fully an investment in another currency?
The hedge ratio measures the relative sensitivity of futures prices to changes in the spot exchange rates. This ratio is
particularly helpful when the changes in futures prices are not perfectly correlated with the changes in the spot
exchange rates.
31. What technique is commonly used to estimate the hedge ratio? What statistical measure is an indicator of the
confidence that should be placed in the estimated hedge ratio? What is the interpretation if the estimated
hedge ratio is greater than 1? Less than 1?
A common method to estimate the hedge ratio is to regress recent changes in spot prices on recent changes in futures
prices. The degree of confidence is measured by the value of R2 for the regression. A value of R2 equal to one
implies perfect correlation between the two price variables. The estimated slope coefficient () from the regression
equation is the estimated hedge ratio or measure of sensitivity between spot prices and futures prices. A value of 
greater than one means that changes in spot prices are greater than changes in futures prices, and the number of
futures contracts must be increased accordingly. A value of  less than one means that changes in spot prices are less
than changes in futures prices, and the number of futures contracts can be decreased accordingly.
32. An FI has assets denominated in British pounds of $125 million and pound liabilities of $100 million. The
exchange rate of dollars for pounds is currently $1.60/£.
a. What is the FI's net exposure?
The net exposure is $125 million - $100 million = $25 million.
b. Is the FI exposed to a dollar appreciation or depreciation?
The FI is exposed to dollar appreciation, or declines in the pound relative to the dollar.
c. How can the FI use futures or forward contracts to hedge its FX rate risk?
The FI can hedge its FX rate risk by selling forward or futures contracts in pounds, assuming the
contracts are quoted as $/£, that is, in direct quote terms in the U.S.
d. If a futures contract is currently trading at $1.55/£, what is the number of futures

contracts that must be utilized to fully hedge the FI's currency risk exposure? Assume
the contract size on the British pound futures contract is £62,500.
Assuming that the contract size for British pounds is £62,500, the FI must sell Nf = ($25
million/1.55)/£62,500 = 258 pound sterling futures contracts.
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e. If the British pound exchange rate falls from $1.60/£ to $1.50/£, what will be the
impact on the FI's cash position?
The cash position will experience a loss if the pound depreciates in terms of the U.S. dollar. The
loss would be equal to (($25 million/$1.60) x 1.50) - $25 million = $23,437,500 - $25 million = -
$1,562,500.
f. If the British pound futures exchange rate falls from $1.55/£ to $1.45/£, what will be
the impact on the FI's futures position?
The gain on the short futures hedge is:
NF x £62,500 x Ft = -258(£62,500)($1.45 - $1.55) = +$1,612,500
g. Using the information in parts (e) and (f ), what can you conclude about basis risk?
In cases where basis risk occurs, a perfect hedge is not possible.
33. An FI is planning to hedge its one-year, 100 million Swiss franc (SF)-denominated loan against exchange rate
risk. The current spot rate is $0.60/SF. A 1-year SF futures contract is currently trading at $0.58/SF. SF
futures are sold in standardized units of SF125,000.
a. Should the FI be worried about the SF appreciating or depreciating?
The FI should be worried about the SF depreciation because it will provide fewer dollars per SF.
b. Should the FI buy or sell futures to hedge against exchange rate risk exposure?
The FI should sell SF futures contracts to hedge this exposure.
c. How many futures contracts should the FI buy or sell if a regression of past changes in
the spot exchange rates on changes in future exchange rates generates an estimated
slope of 1.4?
Nf = (Long asset position x h)/(Futures contract size) = SF100m x 1.4/SF125,000 = 1,120 contracts
d. Show exactly how the FI is hedged if it repatriates its principal of SF100 million at
year-end, the spot exchange rate of SF at year-end is $0.55/SF, and the forward
exchange rate is $0.5443/SF.
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The original loan in dollars = SF100 x $0.60 = $60 million, and the loan value in dollars at year-end = SF100 x
$0.55 = $55 million. The balance sheet has decreased in value by $5,000,000. The gain from hedge = ($0.58 -
$0.5443) x SF125,000 x 1,120 = $4,998,000. The net loss is reduced to just $2,000 by hedging the FX rate risk.
34. A U.S. FI has a long position in £75,500,000 assets funded with U.S. dollar denominated
liabilities. The FI manager is concerned about the £ appreciating relative to the dollar and is
considering a hedge of this FX risk using £ futures contracts. The manager has regressed
recent changes in spot £ exchange rates on changes in £ futures contracts. The resulting
regression equation is: ΔSt = 0.09 + 1.5ΔFt. Further, the Cov(ΔSt, ΔFt) was found to be
0.06844, σΔSt = 0.3234, and σΔft = 0.2279. Pound futures contracts are sold in standardized
units of £62,500. Calculate the number of futures contracts needed to hedge the risk of the
£75,500,000 asset. Calculate the hedging effectiveness of these futures contracts. To what
extent can the manager have confidence that the correct hedge ratio is being used to hedge
the FI’s FX risk position?
£75,500,000 x 1.5
Nf= = 1,812 contracts
£62,500
R2 = [0.06844/(0.3234 x 0.2279)]2 = 86.23%
The manager can have high confidence that the correct hedge ratio is being used to hedge the
FI’s FX risk position.
35. An FI has made a loan commitment of SF10 million that is likely to be taken down in six months. The current
spot rate is $0.60/SF.
a. Is the FI exposed to the dollar’s depreciating or appreciating relative to the SF? Why?
The FI is exposed to the dollar depreciating, because it would require more dollars to purchase the SF10 million if
the loan is drawn down as expected.
b. If the spot rate six months from today is $0.64/SF, what amount of dollars is needed if the loan is taken
down and the FI is unhedged?
The FI needs $0.64 x SF10 million = $6.4 million to make the SF-denominated loan.
c. If the FI decides to hedge using SF futures, should it buy or sell SF futures?
The FI should buy SF futures if it decides to hedge against the depreciation of the dollar.
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d. A six-month SF futures contract is available for $0.61/SF. What net amount would be needed to fund the
loan at the end of six months if the FI had hedged using the SF10 million futures contract? Assume that
futures prices are equal to spot prices at the time of payment (i.e., at maturity).
If it has hedged using futures, the FI will gain ($0.64 - $0.61) x SF10 million = $300,000 on its futures position.
Thus, the net payment will be $6.1 million.
36. A U.S. FI has assets denominated in Swiss francs (SF) of 75 million and liabilities of 125 million. The spot
rate is $0.6667/SF, and one-year futures are available for $0.6579/SF.
a. What is the FI’s net exposure?
The net exposure is –SF50 million.
b. Is the FI exposed to dollar appreciation or depreciation relative to the SF?
The FI is exposed to depreciation of the dollar. If the dollar weakens, the FI will need to pay more dollars to cover
its SF liabilities than it will receive for its assets.
c. If the SF spot rate changes from $0.6667/SF to $0.6897/SF, how will this impact the
FI’s currency exposure? Assume no hedging.
The loss would be SF50,000,000($0.6667 - $0.6897) = -$1,150,000.
d. What is the number of futures contracts necessary to fully hedge the currency risk
exposure of the FI? The contract size is SF125,000 per contract.
The number of contracts = SF50,000,000/SF125,000 = 400 contracts.
e. If the SF futures exchange rate falls from $0.6579/SF to $0.6349/SF, what will be the
impact on the FI’s futures position?
The loss on the futures position would be 400 contracts x SF125,000 x ($0.6349 - $0.6579) =
-$1,150,000.
37. What is a credit forward? How is it structured?
A credit forward is a forward agreement that hedges against an increase in default risk on a loan. The credit forward
specifies a credit spread on a benchmark bond issued by a bank borrower. The credit spread measures a risk
premium above the risk free rate to compensate for default risk.
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Education.
38. What is the gain on the purchase of a $20 million credit forward contract with a modified duration of seven
years if the credit spread between a benchmark Treasury bond and a borrowing firm’s debt decreases by 50
basis points?
The gain would be (ΦT - ΦF) x MD x $20 million = 0.005 x 7 x $20 million = $700,000.
39. How is selling a credit forward similar to buying a put option?
After the loan is made, the FI sells a credit forward. If the credit risk of the borrower decreases sufficiently that the
spread over the benchmark bond increases, the forward seller (the FI) will realize a gain at the maturity of the
forward contract that will offset the decrease in value of the loan. Thus, the FI benefits as the credit risk of the
borrower decreases. This is the exact same situation as a put option buyer when the stock price goes down.
If the credit risk improves, the lender FI will pay the forward buyer because the benchmark spread will have
decreased. However, since the spread can only decrease to zero, the FI has limited loss exposure. This is similar to
paying a premium on a put option.
40. A property-casualty (PC) insurance company has purchased catastrophe futures contracts to hedge against
losses during the hurricane season. At the time of purchase, the market expected a loss ratio of 0.75. After
processing claims from a severe hurricane, the PC actually incurred a loss ratio of 1.35. What amount of
profit did the PC make on each $25,000 futures contract?
The payoff = actual loss ratio x $25,000 = 1.35 x $25,000 = $33,750.
41. What is the primary goal of regulators in regard to the use of futures by FIs? What guidelines have regulators
given banks for trading in futures and forwards?
Regulators of banks have encouraged the use of futures for hedging and have discouraged the
use of futures for speculation. Banks are required to (1) establish internal guidelines regarding
hedging activity, (2) establish trading limits, and (3) disclose large contract positions that
materially affect bank risk to shareholders and outside investors. Finally, FASB requires all firms
to reflect the mark to market value of their derivative positions in their financial statements.
Because of their lack of regulation and because of the significant role that over-the-counter
(OTC) derivative securities played in causing the financial crisis, in the summer of 2009 the
Obama administration proposed a plan to regulate OTC derivatives. The plan, first, called for
most of the OTC derivatives to trade on regulated exchanges which would guarantee trades and
help cushion against potential defaults. This change makes it easier to see market prices of these
securities and make the markets more transparent. Second, like exchanged traded derivatives, the
previous OTC traded securities would now come under the authority of the SEC and the CFTC,
while bank regulators would oversee banks that deal in derivatives. Thus, the changes result in
OTC derivative securities being regulated to the same extent as exchange traded securities.
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Integrated Mini Case: HEDGING INTEREST RATE RISK WITH FUTURES CONTRACTS
Use the following December 31, 2014 market value balance sheet for Bank One to answer the
questions below.
Assets (in thousands of $s) Liabilities/Equity (in thousands of $s)
Value Duration Value Duration

T-bills $1,500 0.75
NOW accounts $ 6,250 0.50
T-bonds 4,250 9.50
CDs 7,500 7.55
Loans 15,500 12.50
Federal funds 5,500 0.10
Equity 2,000
The bank’s manager thinks rates will increase by 0.50 percent in the next 3 months. To
hedge this interest rate risk the manager will use June T-bond futures contracts. The T-
bonds underlying the futures contracts have a maturity = 15 years, a duration = 14.25
years, and a price = 108-10 or $108,312.50. Assume that interest rate changes in the
futures market relative to the cash market are such that br = 0.885.
1. Calculate the leverage adjusted duration gap (DGAP) for Bank One.
DA = [(1,500/21,250)(0.75) + (4,250/21,250)(9.50) + (15,500/21,250)(12.50)] = 11.07058824 years

DL = [(6,250/19,250)(0.50) + (7,500/19,250)(7.55) + (5,500/19,250)(0.10)] = 3.13246753 years
DGAP = 11.07058824 – (19,250/21,250)(3.13246753) = 8.2329 years
2. Using the DGAP model, if interest rates on assets and liabilities increase such that RA/(1 +
RA) = RL/(1 +RL) = 0.0075, calculate the change in the value of assets and liabilities and the
new value of the assets and liabilities for Bank One.
∆A = -11.07058824 x 21,250,000 x 0.0075 = -$1,764,375

=> New asset value = $21,250,000 -$1,764,375 = $19,485,625
∆L = -3.13246753 x 19,250,000 x 0.0075 = -$452,250
=> New liabilities value = $19,250,000 - $452,250 = $18,797,750
3. Calculate the change in the market value of equity for Bank One if rates increase such that
R/(1 +R) = 0.0075.
∆E = -8.2329 x 21,250,000 x 0.0075 = -$1,312,125

=> New equity value = $2,000,000 - $1,312,125 = $687,875
4. Calculate the correct number of futures contracts needed to hedge the bank’s interest
rate risk (do not round to the nearest whole contract). Make sure you specify whether
you should enter the hedge with a short or long futures position.
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Education.
[11.07058935 − ((19,250 / 21,250) x3.13246753)]$21,250,000

Nf = =128.0787946 contracts
14.25x$108,312.50x 0.885
Since DGAP > 0, if interest rates increase, then MVE decreases. So, short futures contracts.
5. Calculate the change in the bank’s market value of equity and the change in the value of the
T-bond futures position for the bank if interest rates increase by 0.55 percent from the current
rate of 6 percent on the T-bonds and increase 0.65 percent from the current rate of 8 percent on
the balance sheet assets and liabilities.
∆E = -8.2329 x 21,250,000 x (0.0065/1.08) = -$1,052,940

∆F = -14.25 x -128.0785 x 108,312.50 x (0.0055/1.06) = $1,025,717
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Chapter 10, 11 and 12

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

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

9. Suppose that a bank does the following:

1. 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%

of + (BR + ) 0.0025 + (0.09 + 0.025) 0.1175

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 )

PDA = 0.105(0.65) - 0.35(0.05) = 0.05075 or 5.0755%

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 – 90 – 30) / 700 = 0.0714 X1 = Working capital/total assets (TA)

Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(0.20) + 0.6(2.6667) + 1.0(0.7143) = 3.104

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

X1 = (20 + 90 + 90 - 30 - 90 - 30) / 700 = 0.0714

Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(-0.0857) + 0.6(1.3333) + 1.0(0.4286) = 1.0754

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

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. Solve 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.

1 - p1 = 0.03 = marginal probability of default in year 1

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

There is an 11.65 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  f = 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.

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

The cumulative survival rate is = (1 - MMR1) x (1 - MMR2) x (1 - MMR3) x (1 - MMR4) x (1 - MMR5)

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%.