You must answer ONE question from Section A.
Suppose that as a loan officer for a bank you just completed a £2 million loan to a small business. This is a bullet loan, senior unsecured, with one-year maturity and carries a 5.5% interest rate. You rate the borrower internally as B, which translates into a one-year probability of default (PD) estimate of 3%. Loss given default (LGD) for the loan is estimated as 45%.
- Determine the expected cash flow from the loan at maturity.
- If the estimated all-inclusive cost of funding for the loan is 2.5% per year, determine the bank’s expected profit (in £) on the loan.
- Now suppose that the bank funds this loan (and possibly many others) with deposits that on average have one-month duration. The current interest rate that the bank pays on these deposits is 1% per year, but recent political developments lead the bank management to believe that interest rates on these deposits may have to be increased in a few months’ time.
- If the bank decides to hedge its interest rate exposure, briefly state how it can utilise a 6×12 forward rate agreement (FRA) for this purpose. No calculations are necessary, state whether the bank should buy the FRA or sell it (if you cannot recall what buying and selling means in the FRA market, answer in terms of paying or receiving LIBOR). Explain your reasoning clearly.
- Now suppose that the bank enters into an FRA in the direction (buy or sell) you identified in part (i), with a notional amount of £2 million. The rate on the contract is 1.5% per year. At the end of the six months, when settlement day comes, 6-month LIBOR turns out to be 2.4% per year. Using a day count of 180 days for the six-month period, determine the payoff to the bank from the FRA on settlement day.
[TOTAL 40 MARKS]
END OF QUESTION ONE
- Find the Macaulay duration of a 2-year, annual coupon-paying bond with 4% coupon rate and 3% yield to maturity. Using the Macaulay duration, estimate the percentage change in the bond’s price if its yield suddenly jumps to 3.25%.
- Briefly discuss Moody’s KMV model. Specifically, explain how distance to default (DD) is estimated and how this is converted to a probability of default (PD) estimate. Be sure to include in your discussion one weakness of this approach to default risk estimation.
- In Basel II and III, banks are required to adopt an internal ratings based (IRB) approach to estimating credit risk. In what ways does this approach differ from Basel I or Basel II’s standardized approach? How do Basel rules entice banks to switch to IRB-based approaches as quickly as possible?
[TOTAL 40 MARKS]