Start by drawing 2 boxes. Label them Firm A and Commercial Bank. Firm A gets a $

Question

Start by drawing 2 boxes. Label them Firm A and Commercial Bank. Firm A gets a $300,000 loan from their neighborhood commercial bank. Each month for 5 years, Firm A must pay the commercial bank a principle payment and an interest payment of the principle times LIBOR + .06. (LIBOR stands for the London Interbank Offer Rate, it is a base interest rate used when banks lend money to each-other. It is common practice to base commercial and mortgage loan interest rates off of LIBOR instead of the US Federal Funds Rate. LIBOR is a more volatile rate than the Fed rate.) Firm A’s monthly payment: prin + prin * (LIBOR + .06) Draw the flows between Firm A and the commercial bank.

Which risks does the commercial bank face?

a. Interest rate risk

b. Default risk

c. Currency risk

d. All of the above

e. A and B only

Explanation / Answer

Here the correct option is "E", => both A and B.

Since, as the "LIBOR", increases, => the possibility of "interest rate to increase" and the possibility of risk in defaulting.

So, "E" be the correct option.

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