3. The following is information on current spot and forward term structures (ass

Question

3. The following is information on current spot and forward term structures (assume the corporate debt pays interest annually) Spot 1 Year Spot 2 Year (1-year maturity) Forward 1-year ercent Treasur BBB Corporate Debt7.5 percent 9.15 percent rcent 4.75 Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the second year is a) 4.20 percent. b) 98.0 percent. c) 2.35 percent. d) 2.71 percent e) 3.88 percent. 4. Suppose that debt-equity ratio (DIE) and the sales-asset ratio (S/A) were two factors influencing the past default behavior ofborrowers. Based on past default (repayment) experience, the linear probability model is estimated as PD0.5(D/E) + 0.1(S/A). If a prospective borower has a debt equity ratio of0.4 and sales-asset ratio of 1.8, the expected probability of default is a) 0.02 b) 0.35 C) 0.38 d) 0.62 e) 0.98 5. Which of the following observations concerning floating-rate loans is NOT true? a) They have less credit risk than fixed-rate loans b) They better enable Fis to hedge the cost ofrising interest rates on liabilities c) They pass the risk ofinterest rate changes onto borrowers d) In rising interest rate environments, borrowers may find themselves unable to pay the interest on their floating-rate loans e) The loan rate can be periodically adjusted according to a formula 6. Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free borrowing rate of8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves are 6 percent. What is the expected or promised gross retum on the loan? a) 11.19 percent b) 11.90 percent C) 12.29 percent d) 12.02 percent e) 12.22 percent

Explanation / Answer

4) Expected probability of default = 0.50(D/E) + 0.10(S/A)

                                                  =0.50*0.40 + 0.10*1.8

                                                   0.38

5) Floating rate loan are the loans where the interest rate is not fixed, the interest rate is depended on say LIBOR plus some percentage. The statement regarding floating loan which is not true is that they have less credit risk than fixed-rate loans. This is not true as the credit risk would be more or same in the floating rate loans

6)

The expected or promised gross return on the loan is 12.22 percent.

Default risk free borrowing rate 0.08 Risk Premium 0.03 Origination Fee 0.001875 Compensating Balance 0.09 Required reserves 0.06 promised gross return on the loan(k) = origination fee+(base lending rate+margin)/1-(compensating balance(1-reserve requirement)) k = 0.001875+(0.08+0.03)/1-(0.09(1-0.06)) k = 0.001875+0.11/(1-0.0846) k= 0.111875/0.9154 k = 0.122214

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