Lecture 01 – ExQu & SolAns

Exercises & Solutions

1. Consider the following balance sheet for MMC Bancorp (in millions of dollars):

Assets Liabilities/Equity

1. Cash and due from $ 6.25 1. Equity capital (fixed) $25.00

2. Short-term consumer loans 62.50

(1-year maturity) 2. Demand deposits 50.00

3. Long-term consumer loans 31.30

(2-year maturity) 3. One-month CDs 37.50

4. Three-month T-bills 37.50 4. Three-month CDs 50.00

5. Six-month T-notes 43.70 5. Three-month bankers’

acceptances 25.00

6. 3-year T-bonds 75.00 6. Six-month commercial paper 75.00

7. 10-year, fixed-rate mortgages 25.00 7. 1-year time deposits 25.00

8. 30-year, floating-rate mortgages

(reset every nine months) 50.00 8. 2-year time deposits 50.00

9. Premises 6.25

$337.50 $337.50

a. Calculate the value of MMC’s rate-sensitive assets, rate sensitive liabilities, and repricing gap over the next
year.

Looking down the asset side of the balance sheet, we see the following one-year rate-sensitive assets (RSA):

1. Short-term consumer loans: $62.50 million, which are repriced at the end of the year and just make the
one-year cut-off.

2. Three-month T-bills: $37.50 million, which are repriced on maturity (rollover) every three months.

3. Six-month T-notes: $43.70 million, which are repriced on maturity (rollover) every six months.

4. 30-year floating-rate mortgages: $50.00 million, which are repriced (i.e., the mortgage rate is reset) every
nine months. Thus, these long-term assets are RSA in the context of the repricing model with a one-year
repricing horizon.

Summing these four items produces one-year RSA of $193.70 million. The remaining $143.80 million is not rate
sensitive over the one-year repricing horizon. A change in the level of interest rates will not affect the interest
revenue generated by these assets over the next year. The $6.25 million in the cash and due from category
and the $6.25 million in premises are nonearning assets. Although the $131.30 million in long-term consumer
loans, 3-year Treasury bonds, and 10-year, fixed-rate mortgages generate interest revenue, the level of
revenue generated will not change over the next year since the interest rates on these assets are not expected
to change (i.e., they are fixed over the next year).
Looking down the liability side of the balance sheet, we see that the following liability items clearly fit the one-
year rate or repricing sensitivity test:

1. One-month CDs: $37.50 million, which mature in one months and are repriced on rollover.

2. Three-month CDs: $50 million, which mature in three months and are repriced on rollover.

3. Three-month bankers’ acceptances: $25 million, which mature in three months and are repriced on
rollover.

4. Six-month commercial paper: $75 million, which mature and are repriced every six months.

5. 1-year time deposits: $25 million, which are repriced at the end of the one-year gap horizon.

Summing these five items produces one-year rate-sensitive liabilities (RSL) of $212.5 million. The remaining
$125 million is not rate sensitive over the one-year period. The $25 million in equity capital and $50 million in
demand deposits do not pay interest and are therefore classified as non-paying. The $50 million in two-year
time deposits generate interest expense over the next year, but the level of the interest generated will not
change if the general level of interest rates change. Thus, we classify these items as fixed-rate liabilities.

The five repriced liabilities ($37.50 + $50 + $25 + $75 + $25) sum to $212.5 million, and the four repriced assets
of $62.50 + $37.50 + $43.70 + $50 sum to $193.70 million. Given this, the cumulative one-year repricing gap
(CGAP) for the bank is:

CGAP = (One-year RSA) - (One-year RSL) = RSA - RSL = $193.70 million - $212.5 million =

-$18.80 million

b. Calculate the expected change in the net interest income for the bank if interest rates rise by 1 percent on
both RSAs and RSLs. If interest rates fall by 1 percent on both RSAs and RSLs.

The CGAP would project the expected annual change in net interest income (NII) of the bank is:

NII = CGAP x R

= (-$18.80 million) x 0.01

= -$188,000

Similarly, if interest rates fall equally for RSAs and RSLs, NII will fall by:

= (-$18.80 million) x (-0.01)

= $188,000

c. Calculate the expected change in the net interest income for the bank if interest rates rise by 1.2 percent on
RSAs and by 1 percent on RSLs. If interest rates fall by 1.2 percent on RSAs and by 1 percent on RSLs.

The resulting change in NII is calculated as:

NII = [RSA x )RRSA] - [RSL x RRSL]

= [$193.70 million x 1.2%] - [$212.5 million x 1.0%]

= $2.3244 million - $2.125 million

= $199,400
2. The balance sheet of A. G. Fredwards, a government security dealer, is listed below. Market yields are in
parentheses and amounts are in millions.

Assets Liabilities and Equity

Cash $20 Overnight repos $340

1-month T-bills (7.05%) 150 Subordinated debt

3-month T-bills (7.25%) 150 7-year fixed rate (8.55%) 300

2-year T-notes (7.50%) 100

8-year T-notes (8.96%) 200

5-year munis (floating rate)

(8.20% reset every 6 months) 50 Equity 30

Total assets $670 Total liabilities and equity $670

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years?

Repricing gap using a 30-day planning period = $150m - $340m = -$190 million.
Repricing gap using a 3-month planning period = ($150m + $150m) - $340m = -$40 million.
Repricing gap using a 2-year planning period = ($150m + $150m + $100m + $50m) - $340m = $110 million.

b. What is the impact over the next three months on net interest income if interest rates on RSAs increase 50
basis points and on RSLs increase 60 basis points?

II = ($150m. + $150m.)(0.005) = $1.5m.

IE = $340m.(0.006) = $2.04m.

NII = $1.5m. – ($2.04m.) = -$0.54m.

c. What is the impact over the next two years on net interest income if interest rates on RSAs increase 50 basis
points and on RSLs increase 60 basis points?

II = ($150m. + $150m. + $100m. + $50m.)(0.005) = $2.25m.

IE = $340m.(0.0060) = $2.04m.

NII = $2.25m. – ($2.04m.) = $0.21m.

d. Explain the difference in your answers to parts (b) and (c). Why is one answer a negative change in NII, while
the other is positive?

For the 3-month analysis, the CGAP affect worked to decrease net interest income. That is, the CGAP was
negative while interest rates increased. Thus, interest income increased by less than interest expense. The
result is a decrease in NII. For the 2-year analysis, the CGAP affect worked to increase net interest income.
That is, the CGAP was positive while interest rates increased. Thus, interest income increased by more than
interest expense. The result is an increase in NII.
3. Use the following information about a hypothetical government security dealer named M. P. Jorgan. Market
yields are in parenthesis, and amounts are in millions.

Assets Liabilities and Equity

Cash $10 Overnight repos $170

1-month T-bills (7.05%) 75 Subordinated debt

3-month T-bills (7.25%) 75 7-year fixed rate (8.55%) 150

2-year business loans (7.50%) 50

8-year mortgage loans (8.96%) 100

5-year munis (floating rate)

(8.20% reset every 6 months) 25 Equity 15

Total assets $335 Total liabilities & equity $335

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall that cash is a non-
interest-earning asset.

Repricing gap using a 30-day planning period = $75m - $170m = -$95 million.
Repricing gap using a 3-month planning period = ($75m + $75m) - $170m = -$20 million.
Reprising gap using a 2-year planning period = ($75m + $75m + $50m + $25m) - $170m = +$55 million.

b. What is the impact over the next 30 days on net interest income if interest rates increase 50 basis points?
Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will decrease by $475,000.

NII = CGAP(R) = -$95m(0.005) = -$0.475m.

If interest rates decrease by 75 basis points, net interest income will increase by $712,500.

NII = CGAP(R) = -$95m(-0.0075) = $0.7125m.

c. The following one-year runoffs are expected: $10 million for two-year business loans and $20 million for
eight-year mortgage loans. What is the one-year repricing gap?

The repricing gap over the 1-year planning period =

= ($75m. + $75m. + $10m. + $20m. + $25m.) - $170m. = +$35 million.

d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates increase 50
basis points? Decrease 75 basis points?

If interest rates increase 50 basis points, net interest income will increase by $175,000.

NII = CGAP(R) = $35m(0.005) = $0.175m.

If interest rates decrease 75 basis points, net interest income will decrease by $262,500.

NII = CGAP(R) = $35m(-0.0075) = -$0.2625m.

Questions & “Answers”

(please, keep in mind that the “answers” whenever provided are indicative and definitely not exhaustive!)

1. Discuss how do monetary policy decisions by central banks impact interest rates how has the increased level
of financial market integration affected interest rates? (chapter 8 pp.208-211)

Through its daily open market operations, such as buying and selling bonds and bills, a central bank seeks to
influence the money supply, inflation, and the level of interest rates. When the central bank finds it necessary
to slow down the economy, it tightens monetary policy by raising interest rates. The normal result is a
decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if
business and household spending decline to the extent that the central bank finds it necessary to stimulate the
economy it allows interest rates to fall (an expansionary monetary policy). Such a drop in interest rates
promote borrowing and spending.

Increased financial market integration, or globalization, increases the speed with which interest rate changes
and volatility are transmitted among countries. The result of this quickening of global economic adjustment is
to increase the difficulty and uncertainty faced by a central bank as it attempts to manage economic activity
within the economy responsible for. Further, because FIs have become increasingly more global in their
activities, any change in interest rate levels or volatility caused by a central bank’s actions more quickly creates
additional interest rate risk issues for these companies.
2. What is the repricing gap, what is meant by rate sensitivity and on what financial performance variable does
the repricing model focus? Explain why is the length of time selected for repricing assets and liabilities
important when using the repricing model. Explain also what is the CGAP effect and if as a bank manager you
were quite certain that interest rates were going to rise/fall within the next six months, how would you adjust
the bank’s six-month repricing gap to take advantage of this anticipated rise/fall?

The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the
dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a
rollover of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a
new loan at current market rates) or because the asset or liability is a variable rate instrument (e.g., a variable
rate mortgage whose interest rate is reset every quarter based on movements in a prime rate). Rate sensitivity
represents the time interval where repricing can occur. The model focuses on the potential changes in the net
interest income variable. In effect, if interest rates change, interest income and interest expense will change as
the various assets and liabilities are repriced, that is, receive new interest rates.

The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The
longer the repricing period, the more securities either mature or will be repriced, and, therefore, the more the
interest rate risk exposure. An excessively short repricing period omits consideration of the interest rate risk
exposure of assets and liabilities are that repriced in the period immediately following the end of the repricing
period. That is, it understates the rate sensitivity of the balance sheet. An excessively long repricing period
includes many securities that are repriced at different times within the repricing period, thereby overstating
the rate sensitivity of the balance sheet.

The CGAP effect describes the relation between changes in interest rates and changes in net interest income.
According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in
interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise.
According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in
interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall.

When interest rates are expected to rise, a bank should set its repricing gap to a positive position. In this case,
as rates rise, interest income will rise by more than interest expense. The result is an increase in net interest
income. When interest rates are expected to fall, a bank should set its repricing gap to a negative position. In
this case, as rates fall, interest income will fall by less than interest expense. The result is an increase in net
interest income.
3. What are some of the weaknesses of the repricing model? How have large banks solved the problem of
choosing the optimal time period for repricing? What is runoff cash flow, and how does this amount affect the
repricing model’s analysis? (chapter 8 pp.221-223)

The repricing model has four general weaknesses:

(1) It ignores market value effects.

(2) It ignores information regarding the distribution of assets and liabilities within time buckets. Thus, if
assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are
subject to reinvestment risks.

(3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities are
withdrawn before the maturity date.

(4) It ignores income generated from off-balance-sheet activities.

Large banks are able to reprice securities every day using their own internal models so reinvestment and
repricing risks can be estimated for each day of the year.

Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn
unexpectedly. To the extent that either of these amounts is significantly greater than expected, the estimated
interest rate sensitivity of the FI will be in error.
Lecture 02 – ExQu & SolAns

Exercises & Solutions

1. Two bonds are available for purchase in the financial markets. The first bond is a two-year,
$1,000 bond that pays an annual coupon of 10 percent. The second bond is a two-year,
$1,000, zero-coupon bond.

a. What is the duration of the coupon bond if the current yield to maturity (R) is 8
percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet program to assist
in the calculations.)

Coupon Bond: Par value = $1,000 Coupon rate = 10% Annual payments
R = 8% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t

1 $100 0.9259 $92.59 $92.59
2 1,100 0.8573 943.07 1,886.15
$1,035.67 $1,978.74
Duration = $1,978.74/$1,035.67 = 1.9106

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.9091 $90.91 $90.91
2 1,100 0.8264 909.09 1,818.18
$1,000.00 $1,909.09
Duration = $1,909.09/$1,000.00 = 1.9091

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
1 $100 0.8929 $89.29 $89.23
2 1,100 0.7972 876.91 1,753.83
$966.20 $1,843.11
Duration = $1,843.11/$966.20 = 1.9076

b. How does the change in the yield to maturity affect the duration of this coupon bond?
Increasing the yield to maturity decreases the duration of the bond.

c. Calculate the duration of the zero-coupon bond with a yield to maturity of 8

percent, 10 percent, and 12 percent.

Zero Coupon Bond: Par value = $1,000 Coupon rate = 0%

R = 8% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8573 $857.34 $1,714.68
$857.34 $1,714.68
Duration = $1,714.68/$857.34 = 2.0000

R = 10% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.8264 $826.45 $1,652.89
$826.45 $1,652.89
Duration = $1,652.89/$826.45 = 2.0000

R = 12% Maturity = 2 years

t CFt DFt CFt x DFt CFt x DFt x t
2 $1,000 0.7972 $797.19 $1,594.39
$797.19 $1,594.39
Duration = $1,594.39/$797.19 = 2.0000

d. How does the change in the yield to maturity affect the duration of the zero-coupon bond?

Changing the yield to maturity does not affect the duration of the zero coupon bond.

e. Why does the change in the yield to maturity affect the coupon bond differently than it
affects the zero-coupon bond?

Increasing the yield to maturity on the coupon bond allows for higher reinvestment income that
more quickly recovers the initial investment. The zero-coupon bond, on the other hand, has no cash
flow (and therefore no reinvestment of income) until maturity.
2. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual
coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94
years. The assets are financed with equity and a $900,000, two-year, 7.25 percent semiannual
coupon capital note selling at par.

a. What is the leverage adjusted duration gap of Financial Institution XY?

The duration of the capital note is 1.8975 years.

Two-year Capital Note (values in thousands of $s)

Par value = $900 Coupon rate = 7.25% Semiannual payments
R = 7.25% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
0.5 32.625 0.9650 31.48 15.74
1 32.625 0.9313 30.38 30.38
1.5 32.625 0.8987 29.32 43.98
2 932.625 0.8672 808.81 1,617.63
900.00 1,707.73
Duration = $1,707.73/$900.00 = 1.8975

The leverage-adjusted duration gap can be found as follows:

Leverage − adjusted duration gap = D A − D L k = 9.94 −1.8975

$900,000
= 8.23 225years
$1,000,000

b. What is the impact on equity value if the relative change in all market interest rates is a
decrease of 20 basis points? Note: The relative change in interest rates is R/(1+R/2) =
-0.0020.

The change in net worth using leverage adjusted duration gap is given by:

E = − D A − D L k  * A *
R
R

= − 9.94 − (1.8975) 9
10

(1,000,000)( −0.0020) = $16,464
1+
2
c. Using the information calculated in parts (a) and (b), what can be said about the
desired duration gap for the financial institution if interest rates are expected to increase or
decrease.

If the FI wishes to be immune from the effects of interest rate risk (either positive or negative
changes in interest rates), a desirable leverage-adjusted duration gap (DGAP) is zero. If the FI is
confident that interest rates will fall, a positive DGAP will provide the greatest benefit. If the FI is
confident that rates will increase, then negative DGAP would be beneficial.

d. Verify your answer to part (c) by calculating the change in the market value of equity
assuming that the relative change in all market interest rates is an increase of 30 basis
points.
 R
E = − D A − D L k * A * = − 8.23225(1,000,000)(0.003) = − $24,697
R
1+
2
e. What would the duration of the assets need to be to immunize the equity from changes in
market interest rates?

Immunizing the equity from changes in interest rates requires that the DGAP be 0. Thus, (DA-DLk) = 0
 DA = DLk, or DA = 1.8975x0.9 = 1.70775 years.
3. A financial institution has an investment horizon of two years 9.33 months (or 2.777 years).
The institution has converted all assets into a portfolio of 8 percent, $1,000, three-year bonds that
are trading at a yield to maturity of 10 percent. The bonds pay interest annually. The portfolio
manager believes that the assets are immunized against interest rate changes.

a. Is the portfolio immunized at the time of bond purchase? What is the duration of
the bonds?

Three-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 3 years
t CFt DFt CFt x DFt CFt x DFt x t
1 80 0.9091 72.73 72.73
2 80 0.8264 66.12 132.23
3 1,080 0.7513 811.42 2,434.26
950.26 2,639.22
Duration = $2,639.22/$950.26 = 2.777

The bonds have a duration of 2.777 years, which is 33.33 months. For practical purposes, the bond
investment horizon is immunized at the time of purchase.

b. Will the portfolio be immunized one year later?

After one year, the investment horizon will be 1 year, 9.33 months (or 1.777 years). At this time, the
bonds will have a duration of 1.9247 years, or 1 year, 11+ months. Thus, the bonds will no longer be
immunized.

Two-year Bonds
Par value = $1,000 Coupon rate = 8% Annual payments
R = 10% Maturity = 2 years
t CFt DFt CFt x DFt CFt x DFt x t
1 $80 0.9091 72.73 72.73
2 $1,080 0.8264 892.56 1,785.12
965.29 1,857.85
Duration = $1,857.85/$965.29 = 1.9247
 c. Assume that one-year, 8 percent zero-coupon bonds are available in one year. What
proportion of the original portfolio should be placed in these bonds to rebalance the portfolio?

The investment horizon is 1 year, 9.33 months, or 21.33 months. Thus, the proportion of bonds that
should be replaced with the zero-coupon bonds can be determined by the following analysis:

21.33 months = wzero x 12 months + (1 – wzero)x1.9247x12 months  wzero = 15.92 percent

Thus, 15.92 percent of the bond portfolio should be replaced with the zero-coupon bonds after one
year.
Questions & “Answers”

(please, keep in mind that the “answers” whenever provided are indicative and definitely not
exhaustive!)

1. State and discuss the Features of Duration with the help of a coupon bond example (chapter 9
pp.247-249)

2. State and discuss the Economic meaning of Duration with the help of a coupon bond example
(chapter 9 pp.249-253)

3. Briefly identify three criticisms of using the duration gap model to immunize the portfolio of a
financial institution. Explain what is convexity, why it is a desirable feature to capture in a portfolio
of assets and discuss why it is critical for an FI manager who has a portfolio immunized to match a
desired investment horizon to rebalance the portfolio periodically. (chapter 9 pp.265-269)

The three criticisms are:

a Immunization is a dynamic problem because duration changes over time. Thus, it is

necessary to rebalance the portfolio as the duration of the assets and liabilities change
over time.
b Duration matching can be costly because it is not easy to restructure the balance sheet
periodically, especially for large FIs.

c Duration is not an appropriate tool for immunizing portfolios when the expected interest
rate changes are large because of the existence of convexity. Convexity exists because the
relationship between security price changes and interest rate changes is not linear, which
is assumed in the estimation of duration. Using convexity to immunize a portfolio will
reduce the problem.

Convexity is a property of fixed-rate assets that reflects nonlinearity in the reflection of price-yield
relationships. This characteristic is similar to buying insurance to cover part of the interest rate risk
faced by the FI. The more convexity in the price-yield relationship for a given asset, the more
insurance against interest rate changes is purchased.

Assets approach maturity at different rates of speed than the duration of the same assets
approaches zero. Thus, after a period of time, a portfolio of assets that was immunized against
interest rate risk will no longer be immunized. In fact, portfolio duration will exceed the remaining
time in the investment or target horizon, and changes in interest rates could prove costly to the
institution.

The growth of purchased funds markets, asset securitization, and loan sales markets have
considerably increased the speed of major balance sheet restructurings. Further, as these markets
have developed, the cost of the necessary transactions has also decreased. Finally, the growth and
development of the derivative securities markets provides significant alternatives to managing the
risk of interest rate movements only with on-balance-sheet adjustments.
Lecture 03 - ExQu & SolAns

Exercises & Solutions

1

a.
Why is credit risk analysis an important component of FI risk management? What recent activities by
FIs have made the task of credit risk assessment more difficult for both FI managers and regulators?

Credit risk management is important for FI managers because it determines several features of a
loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis
before loans are approved. If credit risk analysis is inadequate, default rates could be higher and
push a bank into insolvency, especially if markets are competitive and margins are low.

Credit risk does not apply only to traditional areas of lending and bond investing. As banks and other
FIs have expanded into credit guarantees and other off-balance-sheet activities, new types of credit
risk exposure have arisen, causing concern among managers and regulators. Credit quality problems,
in the worst case, can cause an FI to become insolvent or can result in such a significant drain on
capital and net worth that they adversely affect its growth prospects and ability to compete with
other domestic and international FIs.

b.
Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate
loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?

A secured loan is backed by some of the collateral that is pledged to the lender in the event of
default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
Secured debt is senior to an unsecured loan (or junior debt) that has only a general claim on the
assets of the borrower if default occurs. With a fixed-rate loan, the lender bears the risk of interest
rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall
the lender benefits. Since it is harder to predict longer-term rates, FIs prefer to charge floating rates
for longer-term loans and pass the interest rate risk on to the borrower. With floating rate loans, the
loan rate can be periodically adjusted according to a formula so that the interest rate risk is
transferred in large part from the FI to the borrower.

c.

How does a spot loan differ from a loan commitment? What are the advantages and disadvantages
of borrowing through a loan commitment?

A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan
commitment allows a borrower the option to take down the loan any time during a fixed period at a
predetermined rate. This can be advantageous during periods of rising rates in that the borrower
can borrow as needed at a predetermined rate. If rates decline, the borrower can borrow from other
sources. The disadvantage is the cost: often an up-front fee is required in addition to a back-end fee
for the unused portion of the commitment.
2

a.

Why are most retail borrowers charged the same rate of interest, implying the same risk premium or
class? What is credit rationing? How is it used to control credit risks with respect to retail and
wholesale loans?

Most retail loans are small in size relative to the overall investment portfolio of an FI and the cost of
collecting information on household borrowers is high. As a result, most retail borrowers are
charged the same rate of interest that implies the same level of risk.

Credit rationing involves restricting the amount of loans that are available to individual borrowers.
On the retail side, the amount of loans provided to borrowers may be determined solely by the
proportion of loans desired in this category rather than price or interest rate differences, thus the
actual credit quality of the individual borrowers. On the wholesale side, the FI may use both credit
quantity and interest rates to control credit risk. Typically, more risky borrowers are charged a
higher risk premium to control credit risk. However, the expected returns from increasingly higher
interest rates that reflect higher credit risk at some point will be offset by higher default rates. Thus,
rationing credit through quantity limits will occur at some interest rate level even though positive
loan demand exists at even higher risk premiums.

b.

Why could a lender’s expected return be lower when the risk premium is increased on a loan? In
addition to the risk premium, how can a lender increase the expected return on a wholesale loan?

An increase in risk premiums indicates a riskier pool of clients who are more likely to default by
taking on riskier projects. This reduces the repayment probability and lowers the expected return to
the lender. The lender often is able to charge fees that increase the return on the loan. However, the
fees may become sufficiently high as to increase the risk of nonpayment or default on the loan.

c.

What are covenants in a loan agreement? What are the objectives of covenants?

Covenants are restrictions that are written into loan or bond contracts that affect the actions of the
borrower. Covenants can include limits on the type and amount of new debt, investments, and asset
sales the borrower may undertake while the loan or bonds are outstanding. Financial covenants are
also often imposed restricting changes in the borrower’s financial ratios such as its leverage ratio or
current ratio. For example, a common restrictive covenant included in many bond and loan contracts
limits the amount of dividends a firm can pay to its equity holders. Clearly, for any given cash flow, a
high dividend payout to stockholders means that less is available for repayments to bondholders and
lenders. Moreover, bond yields, like wholesale loan rates, usually reflect risk premiums that vary
with the perceived credit quality of the borrower and the collateral or security backing of the debt.
Given this, FIs can use many of the following models that analyze default risk probabilities either in
making lending decisions or when considering investing in corporate bonds offered either publicly or
privately.
3.

a.

What is RAROC? How does this model use the concept of duration to measure the risk exposure of a
loan? How is the expected change in the credit risk premium measured? What precisely is LN in the
RAROC equation?

RAROC is a measure of expected loan net income in the form of interest plus fees less cost of
funding relative to some measure of asset risk. One version of the RAROC model uses the duration
model to measure the change in the value of the loan for given changes or shocks in credit quality.
While the loan’s duration and the loan amount are easily estimated, it is more difficult to estimate
the maximum change in the credit risk premium on the loan over the next year. Since publicly
available data on loan risk premiums are scarce, we turn to publicly available corporate bond market
data to estimate premiums. First, an S&P credit rating (AAA, AA, A, and so on) is assigned to a
borrower. Thereafter, the available risk premium changes of all the bonds traded in that particular
rating class over the last year are analyzed. The change in credit quality (R) is measured by finding
the change in the spread in yields between Treasury bonds and corporate bonds of the same risk
class on the loan. The actual value chosen is the highest change in yield spread for the same maturity
or duration value assets. In this case, LN represents the change in loan value or the change in
capital for the largest reasonable adverse changes in yield spreads. The actual equation for LN
looks very similar to the duration equation.

Net Income R
RAROC = where LN = − DLN x LN x where R is the change in yield spread .
Loan risk (or LN ) 1+ R

b.

An FI wants to evaluate the credit risk of a $5 million loan with a duration of 4.3 years to a AAA
borrower. There are currently 500 publicly traded bonds in that class (i.e., bonds issued by firms with
a AAA rating). The current average level of rates (R) on AAA bonds is 8 percent. The largest increase
in credit risk premiums on AAA loans, the 99 percent worst-case scenario, over the last year was
equal to 1.2 percent (i.e., only 6 bonds out of 500 had risk premium increases exceeding the 99
percent worst case). The projected (one-year) spread on the loan is 0.3 percent and the FI charges
0.25 percent of the face value of the loan in fees. Calculate the capital at risk and the RAROC on this
loan.

The estimate of loan (or capital) risk is:

ΔLN = -DLN x LN x (ΔR/(1 + R)) = -4.3 x $5m x (0.012/(1 + 0.08)) = $238,889

While the market value of the loan amount is $5 million, the risk amount, or change in the loan’s
market value due to a decline in its credit quality, is $238,889. Thus, the denominator of the RAROC
equation is this possible loss, or $238,889. To determine whether the loan is worth making, the
estimated loan risk is compared with the loan’s income (spread over the FI’s cost of funds plus fees
on the loan).

Spread = 0.003 x $5 million = $15,000

Fees = 0.0025 x $5 million = $12,500

$27,500

The loan’s RAROC is:

RAROC = $27,500/238,889 = 11.51%

Exercises

1. Assume a one-year Treasury strip is currently yielding 5.5 percent and an AAA-rated discount
bond with similar maturity is yielding 8.5 percent.

a. If the expected recovery from collateral in the event of default is 50 percent of principal
and interest, what is the probability of repayment of the AAA-rated bond? What is the
probability of default?

p(1 + k) +  (1 - p)(1 + k) = 1 + i. Solving for the probability of repayment (p):

1+ i
−  1.055 − 0.5
1+ k
p= = 1.085 = 0.9447 or 94 .47 percent
1−  1 − 0.5

Therefore the probability of default is 1.0 - 0.9447 = 0.0553 or 5.53 percent.

b. What is the probability of repayment of the AAA-rated bond if the expected recovery from
collateral in the case of default is 94.47 percent of principal and interest? What is the
probability of default?
1+ i
−  1.055 − 0.9447
1+ k
p= = 1.085 = 0.5000 or 50 .00 percent
1−  1 − 0.9447

Therefore the probability of default is 1.0 – 0.5000 = 0.5000 or 50.00 percent.

c. What is the relationship between the probability of default and the proportion of principal
and interest that may be recovered in case of default on the loan?

The proportion of the loan’s principal and interest that is collectible on default is a perfect substitute
for the probability of repayment should such defaults occur.
2. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge
a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The
cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the
maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2
percent, based on two years of historical data. The current market interest rate for loans in this
sector is 12 percent.

a. Using the RAROC model, determine whether the bank should make the loan?

RAROC = Fees and interest earned on loan/Loan or capital risk

Loan risk, or LN = -DLN x LN x (R/(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. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:

$125,000/LN = 0.10  LN = 125,000 / 0.10 = $1,250,000

 -DLN x LN x (R/(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. Assuming that duration cannot be changed, how much additional interest and fee income
will be necessary to make the loan acceptable?
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. Given the proposed income stream and the negotiated duration, what adjustment in the
loan rate would be necessary to make the loan acceptable?

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
3. Consider the following company balance sheet and income statement.

Balance Sheet:
Assets Liabilities and Equity
Cash $4,000 Accounts payable $30,000
Accounts receivable 52,000 Notes payable 12,000
Inventory 40,000 Total current liabilities 42,000
Total current assets 96,000 Long-term debt 36,000
Fixed assets 44,000 Equity 62,000
Total assets $140,000 Total liabilities and equity $140,000

Income Statement
Sales (all on credit) $200,000
Cost of goods sold 130,000
Gross margin 70,000
Selling and administrative expenses 20,000
Depreciation 8,000
EBIT 42,000
Interest expense 4,800
Earning before tax 37,200
Taxes 11,160
Net income $26,040

For this company, calculate the following:

a. Current ratio.

96,000/42,000 = 2.2857X

b. Number of days' sales in receivables.

52,000 x 365/200,000 = 94.90 days

c. Sales to total assets.

200,000/140,000 = 1.4286X

d. Number of days in inventory.

40,000 x 365/130,000 = 112.31 days

e. Debt to assets ratio.

(42,000 + 36,000)/140,000 = .5571 = 55.71%

f. Cash flow to debt ratio.

(42,000 + 8,000)/(42,000 + 36,000) = .6410 = 64.10%

g. Return on assets.

26,040/140,000 = 0.1860 = 18.60%

h. Return on equity.

26,040/62,000 = 0.4200 = 42.00%

Lecture 04 - ExQu & SolAns

Questions & Answers

1.

a. How do loan portfolio risks differ from individual loan risks?

Loan portfolio risks refer to the risks of a portfolio of loans as opposed to the risks of a single
loan. Inherent in the distinction is the elimination of some of the borrower-specific risks of
individual loans because of benefits from diversification.

b. What is migration analysis? How do FIs use it to measure credit risk concentration? What are its
shortcomings?

Migration analysis uses information from the market to determine the credit risk of an
individual loan or sectoral loans. With this method, FI managers track credit ratings, such as
S&P and Moody’s ratings, of firms in particular sectors or ratings classes for unusual declines
to determine whether firms in a particular sector are experiencing repayment problems. This
information can be used to either curtail lending in that sector or to reduce maturity and/or
increase interest rates. A problem with migration analysis is that the information may be too
late, because ratings agencies usually downgrade issues only after the firm or industry has
experienced a downturn.

c. What does loan concentration risk mean?

Loan concentration risk refers to the extra risk borne by having too many loans concentrated
with one firm, industry, or economic sector. To the extent that a portfolio of loans represents
loans made to a diverse cross section of the economy, concentration risk is minimized.

d. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of
capital.

i. If the average historical losses in the automobile sector total 8 percent, what is the
maximum loan a manager can lend to firms in this sector as a percentage of total capital?
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.08
= 62.5 percent of capital is the maximum amount that can be lent to firms in the
automobile sector.

ii. If the average historical losses in the mining sector total 15 percent, what is the maximum
loan a manager can lend to firms in this sector as a percentage of total capital?

Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = 0.05 x 1/0.15
= 33.3 percent of capital is the maximum amount that can be lent to firms in the mining
sector.
2.

a. An FI has set a maximum loss of 2 percent of total capital as a basis for setting concentration
limits on loans to individual firms. If it has set a concentration limit of 25 percent to a firm,
what is the expected loss rate for that firm?

Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate)

25 percent = 2 percent x 1/Loss rate => Loss rate = 0.02/0.25 = 8 percent

b. Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s portfolio.

The fundamental lesson of modern portfolio theory is that, to the extent that an FI manager
holds widely traded loans and bonds as assets, or can calculate loan or bond returns, portfolio
diversification models can be used to measure and control the FI’s aggregate credit risk
exposure. By taking advantage of its size, an FI can diversify considerable amounts of credit
risk as long as the returns on different assets are imperfectly correlated with respect to their
default risk adjusted returns. By fully exploiting diversification potential with bonds or loans
whose returns are negatively correlated or that have a low positive correlations with those in
the existing portfolio, the FI manager can produce a set of efficient frontier portfolios, defined
as those portfolios that provide the maximum returns for a given level of risk or the lowest risk
for a given level of returns. By choosing portfolios on the efficient frontier, an FI manager may
be able to reduce credit risk to the fullest extent. As shown in Figure 11-2, a manager’s
selection of a particular portfolio on the efficient frontier is determined by the risk-return
trade-off.

c. Suppose that an FI holds two loans with the following characteristics:

Loan i Xi Ri σi σi2 .

1 0.55 8% 8.55% 73.1025% ρ12 = 0.24

2 0.45 10 9.15 83.7225 σ12 = 18.7758

Calculate the return and risk of the portfolio.

The return on the loan portfolio is: Rp = 0.55 (8%) + 0.45 (10%) = 8.90%

The risk of the portfolio is:

σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (18.7758%) = 48.36133%

or σp2 = (0.55)2 (73.1025%) + (0.45)2 (83722.5%) + 2 (0.55) (0.45) (0.24)(8.55%)(9.15%) =

48.36133% and σp = √ 48.36133% = 6.95%

Notice that the risk (or standard deviation of returns) of the portfolio, σp (6.95 percent), is less
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.
3.

a. Why is it difficult for small banks and thrifts to measure credit risk using modern portfolio
theory?

The basic premise behind modern portfolio theory is the ability to diversify and reduce risk by
eliminating diversifiable risk. Small banks and thrifts may not have the ability to diversify their
asset base, especially if the local markets which they serve have a limited number of
industries. The ability to diversify is even more acute if these loans cannot be traded easily.

b. What is the minimum risk portfolio? Why is this portfolio usually not the portfolio chosen by
FIs to optimize the return-risk trade-off?

The minimum risk portfolio is the combination of assets that reduces portfolio risk as
measured by the standard deviation of returns to the lowest possible level. This portfolio
usually is not the optimal portfolio choice because the returns on this portfolio are low relative
to other alternative portfolio selections. By accepting some additional risk, portfolio managers
are able to realize a higher level of return relative to the risk of the portfolio.

c. The obvious benefit to holding a diversified portfolio of loans is to spread risk exposures so
that a single event does not result in a great loss to an FI. Are there any benefits to not being
diversified?

One benefit to not being diversified is that an FI that lends to a certain industrial or geographic
sector is likely to gain expertise about that sector. Being diversified requires that the FI
becomes familiar with many more areas of business. This may not always be possible,
particularly for small FIs.
Exercises & Solutions
1. Information concerning the allocation of loan portfolios to different market sectors is
given below.
Allocation of Loan Portfolios in Different Sectors (%) .

Sectors National Bank A Bank B

Commercial 30% 50% 10%

Consumer 40 30 40

Real Estate 30 20 50

Bank A and Bank B would like to estimate how much their portfolios deviate from the national
average.

a. Which bank is further away from the national average?

Using Xs to represent portfolio holdings:

Bank A Bank B
(X1j - X1 )2 (0.50 - 0.30)2 = 0.0400 (0.10 - 0.30)2 = 0.0400
(X2j - X2 )2 (0.30 - 0.40)2 = 0.0100 (0.40 - 0.40)2 = 0.0000

(X3j - X3 )2 (0.20 - 0.30)2 = 0.0100 (0.50 - 0.30)2 = 0.0400

n n =3 n =3


i −1
( X ij −X i ) 2  = 0.0600
i =1
 = 0.0800
i =1

 (X ij − X i )2
= i =1
A = 14.14 percent B = 16.33 percent
n
Bank B deviates from the national average more than Bank A.

b. Is a large standard deviation necessarily bad for an FI using this model?

No, a higher standard deviation is not necessarily bad for an FI because the FI could have
comparative advantages that are not required or available to a national well-diversified bank.
For example, an FI could generate high returns by serving specialized markets or product
niches that are not well diversified. Further, an FI could specialize in only one product, such as
mortgages, but be well-diversified within this product line by investing in several different
types of mortgages that are distributed both nationally and internationally. This would still
enable it to obtain portfolio diversification benefits that are similar to the national average.
2. A five-year fixed-rate loan of $100 million carries a 7 percent annual interest rate. The borrower is
rated BB. Based on hypothetical historical data, the probability distribution given below has been
determined for various ratings upgrades, downgrades, status quo, and default possibilities over the
next year. Information also is presented reflecting the forward rates of the current Treasury yield
curve and the annual credit spreads of the various maturities of BBB bonds over Treasuries.

New Loan
Probability Value plus Forward Rate Spreads at Time t
Rating Distribution Coupon $ t rt% ϕt% .

AAA 0.01% $114.82m 1 3.00% 0.72%

AA 0.31 114.60m 2 3.40 0.96

A 1.45 114.03m 3 3.75 1.16

BBB 6.05 4 4.00 1.30

BB 85.48 108.55m

B 5.60 98.43m

CCC 0.90 86.82m

Default 0.20 54.12m

a. What is the present value of the loan at the end of the one-year risk horizon for the case
where the borrower has been upgraded from BB to BBB?

$7m $7m $7m $107m

PV = $7m + + 2
+ + = $113.27 million
1.0372 (1.0436) 3
(1.0491) (1.0530) 4

b. What is the mean (expected) value of the loan at the end of year 1?

Year-end Probability Value Probability x Deviation Probability x

Rating (m of $) Value Deviation Squared

AAA 0.0001 $114.82 $0.01 6.76 0.0046

AA 0.0031 114.60 0.36 6.54 0.1325

A 0.0145 114.03 1.65 5.97 0.5162

BBB 0.0605 113.27 6.85 5.21 1.6402

BB 0.8548 108.55 92.79 0.49 0.2025

B 0.056 98.43 5.51 -9.63 5.1968

CCC 0.009 86.82 0.78 -21.24 4.0615

Default 0.002 54.12 0.11 -53.94 5.8197

1.000
 Mean = $108.06m

Variance = 17.5740

Standard Deviation = $4.19m

The solution table reveals a value of $108.06 million.

c. What is the volatility of the loan value at the end of year 1?

The volatility or standard deviation of the loan value is $4.19 million.

d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal distribution of
values.

The 5 percent VAR is 1.65 x $4.19m = $6.91m.

The 1 percent VAR is 2.33 x $4.19m = $9.76m.

e. Estimate the approximate 5 percent and 1 percent VARs using the actual distribution of
loan values and probabilities.

5% VAR = 95% of actual distribution = $108.06m - $98.43m = $9.63m

1% VAR = 99% of actual distribution = $108.06m - $86.82m = $21.24m

where: 5% VAR is approximated by 0.056 + 0.009 + 0.002 = 0.067 or 6.7 percent, and

1% VAR is approximated by 0.009 + 0.002 = 0.011 or 1.1 percent.

Using linear interpolation, the 5% VAR = $10.65 million and the 1% VAR = $19.31 million.
For the 1% VAR, $19.31m = (1 – 0.1/1.1) x $21.24m.

f. How do the capital requirements of the 1 percent VARs calculated in parts (d) and (e)
above compare with the capital requirements of the BIS and Federal Reserve System?

The Fed and BIS systems would require 8 percent of the loan value, or $8 million. The 1
percent VAR would require $19.31 million under the approximate method, and $9.76
million (2.33 x $4.19m) in capital under the normal distribution assumption. In each case,
the amounts exceed the Fed/BIS amount.
3. An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have a historical average
default rate of 4 percent and the severity of loss is 40 cents per dollar.

a. Over the next year, what are the probabilities of having default rates of 2, 3, 4, 5, and 8
percent?

e − m m n (2.71828) −4 x 4 2 0.018316x16
Pr obability of 2 defaults = = = = 0.1465 = 14.65%
n! 1x 2 2

e − m m n (2.71828) −4 x 43 0.018316x16
Pr obability of 3 defaults = = = = 0.1465 = 19.54%
n! 1x 2x3 6

n 2 3 4 5 8 .

Probability 14.65% 19.54% 19.54% 15.63% 2.98%

b. What would be the dollar loss on the portfolios with default rates of 4 and 8 percent?

Dollar loss of 4 loans defaulting = 4 x 0.40 x $10,000 = $16,000

Dollar loss of 8 loans defaulting = 8 x 0.40 x $10,000 = $32,000

c. How much capital would need to be reserved to meet the 1 percent worst-case loss
scenario? What proportion of the portfolio’s value would this capital reserve be?

The probability of 8 defaults is ~3 percent. The probability of 10 defaults is 0.00529 or

rounded up to 1 percent. The dollar loss of 10 loans defaulting is $40,000. Thus, a 1
percent chance of losing $40,000 exists.

A capital reserve should be held to meet the difference between the unexpected 1 percent
loss rate and the expected loss rate of 4 defaults. This difference is $40,000 minus $16,000
or $24,000. This amount is 0.024 percent of the total portfolio.