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.

3. What is the default risk premium for Firm A?

a. LIBOR

b. 2%

c. 5%

d. 6%

e. 0.6%

Explanation / Answer

As the LIBOR increases,the possibility of interest rate to increase and the possibility of risk in defaulting.

Firm A        

Commercial Loan = $ 3,00,000

P* (LIBOR+.06)

The risk premium is LIBOR as the it will be the minimum amount charged along with the premium amount charged even if the firm A comes out to be a commercial bank and if not then also the firm A will have to pay this amount plus the other fixed rate.
hence option a is the correct option.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.