7. What refers to the risk that the borrower is unable or unwilling to fulfill t

Question

7. What refers to the risk that the borrower is unable or unwilling to fulfill the terms promised under the loan contract? a) Liquidity risk. b) Interest rate risk. c) Sovereign risk. d) Default risk. e) Solvency risk. 8. Suppose that debt-equity ratio (D/E) and the sales-asset ratio (S/A) were two factors influencing the past default behavior of borrowers. Based on past default (repayment) experience, the linear probability model is estimated as: PDi0.5(DIE) +0.1(S/A). If a prospective borrower 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 9. If the spot interest rate on a prime-rated one-month CD is 6 percent today and the market rate on a two-month maturity prime-rated CD is 7 percent today, the implied forward rate on a one-month CD to be delivered one month from today is a) 9 percent b) 11 percent. c) 18 percent. d) 10 percent. e) 8 percent 10. 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 3.0 percent 4.75 percent Treasur BBB Corporate Debt7.5 percent 9.15 percent Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the current year is a) 98.0 percent. b) 2.35 percent c) 4.19 percent d) 3.90 percent e) 2.71 percent.

Explanation / Answer

7. Borrower is unable or unwilling to fulfill the terms promised under the loan contract - Ans. d)Default Risk

8.Expected Probability of Default =0.5*(D/E) +0.1*(S/A) = 0.5*0.4 +0.1*1.8 =0.20+0.18=0.38

So, ans will be c)0.38

9. Implied forward rate =((60*0.07 - 30*0.06)/((60-30))*(1/(1+(0.06*30/360))) =0.0796 or 8%(approx),

where 60= 2 months, 30=1 months,0.07=2 months rate, 0.06=1 month rate

so, ans will be e) 8 percent

10. Risk free 1 Year forward rate for Treasury will be=(0.0475*2-0.03*1)/(2-1) =0.065, where 0.0475=2-year spot rate, 0.03=1 year spot rate

1 Year forward rate for BBB Corporate Debt will be=(0.0915*2-0.075*1)/(2-1)=0.108, where 0.0915=2-year spot rate, 0.075=1 year spot rate

credit spread=.108-.065=.043 , recover rate=.065*40%(assumed)=.026

implied probabilty of default=.043/(1-.026)=4% (around)

so, answer will be c) 4.19 percent

probabilty of default will be=

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