Dr.
Le Anh Tuan
Solutions for Credit Risk
S5.1
a.
RAROC = Fees and interest earned on loan/Loan or capital risk
Loan risk, or ΔLN = -DLN x LN x (ΔR/(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
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.
For RAROC to be 10 percent, loan risk should be:
$125,000/ΔLN = 0.10 ⇒ ΔLN = 125,000 / 0.10 = $1,250,000
⇒ -DLN x LN x (ΔR/(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.
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.
Need an additional $15,625 => $15,625/$5,000,000 = 0.003125 or 0.3125%
Expected interest = 0.123125 x $5,000,000 = $615,625
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 = $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.
Dr. Le Anh Tuan
S5.2
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. ΔLN = -4.5 x $2m x (0.055/1.10) = -$450,000
Expected interest = 0.10 x $2,000,000 = $200,000
Servicing fees = 0.0075 x $2,000,000 = $15,000
Less cost of funds = 0.08 x $2,000,000 = -$160,000
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.
S5.3
The return on the loan portfolio is:
R = 0.55 (8%) + 0.45 (10%) = 8.90%
p
The risk of the portfolio is:
σ = (0.55) (73.1025%) + (0.45) (83722.5%) + 2 (0.55) (0.45) (18.7758%) = 48.36133%
p
2 2 2
or σ = (0.55) (73.1025%) + (0.45) (83722.5%) + 2 (0.55) (0.45) (0.24)(8.55%)(9.15%) =
p
2 2 2
48.36133%
and σ = √ 48.36133% = 6.95%
p
Notice that the risk (or standard deviation of returns) of the portfolio, σ (6.95 percent), is less
p
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.
Dr. Le Anh Tuan
S5.4
a.
For a single asset, expected return :
+
𝐸 (𝑥 ) = 𝜇 = ( 𝑥) 𝑃(𝑥) )
),-
Variance:
+
𝜎 = ((𝑥) − 𝜇)/ 𝑃(𝑥) )
/
),-
Probability of Occurrence Return of loan A Return of loan B Return of loan C
Depression 0.25 0.08 0 0.08
Recession 0.1 0.15 0.06 0.11
Normal 0.35 0.2 0.12 0.15
Boom 0.3 0.3 0.22 0.37
Expected return 19.5% 11.4% 19.5%
Variance 0.007 0.007 0.014
SD 8.3% 8.3% 11.8%
weight 0.4 0.6
correlation A & C -0.8
Portfolios:
Mean 19.5%
Variance 0.002
SD 4.9%
b. With the same risk, the expected return of loan B is lower than A, we would reject B.
With the same expected return, loan A has lower risk (SD), the rank is A>C>B
c. Ep=0.4*19.5%+0.6*19.5%=19.5%
d. The risk of the portfolio is greater than that of loans A and C. The correlation between
loans A and C is negative, indicating that when constructing a portfolio of these loans will
reduce the overall credit risk exposure.
e. When the correlation becomes 0.7, the risk of the portfolio is 9.7%. This raises an important
point that the benefit of diversification will be reduced once the correlation coefficients are
strongly positive.