Q&A Hero

Q: Recessionary phases in the business cycle typically cause greater hardship on companies that borrow large amounts.

Q: The amount of leverage of a borrower and the probability of default are positively related, but only after some minimum level of debt.

Q: A borrower's reputation is an example of a market-specific factor in the credit decision.

Q: Covenants are restrictions in loan and bond agreements that encourage or forbid certain actions by the borrower.

Q: There is a positive relationship between the interest rate charged on a retail loan and the expected return on the loan.

Q: Generally, at the retail level, an FI controls credit risks solely by using a range of interest rates or prices and not by credit rationing.

Q: Credit rationing is a form of managing credit risk.

Q: At some point, further increases in interest rates on specific loans may decrease expected loan returns because of increased probability of default by the borrower.

Q: Because of compensating balances and fees used to increase return on a loan, the credit risk premium is not the fundamental factor driving the promised return once the base rate on the loan has been set.

Q: Adjusting interest rates, fees, and other terms upward for increasing amounts of default risk is a way to attempt to realize the expected return on the loan.

Q: Because a compensating balance is the proportion of a loan that must be kept on deposit at the lending institution, the actual return to the lender on the usable portion of these loans is higher.

Q: LIBOR, the London Interbank Offered Rate, is the rate for short-term interbank dollar loans in the domestic money-center bank market.

Q: Relationship pricing involves pricing for specific services which depend, in part, on the amount or number of services that are used by the customer.

Q: Usury ceilings are maximum rates imposed by federal legislation that FIs can charge on consumer and mortgage debt.

Q: Adjustable rate mortgages have interest rates that adjust periodically according to the movement in some index.

Q: Because they are secured by homes, residential mortgages have demonstrated very little credit risk for FIs.

Q: Since their introduction, the proportion of ARMs to fixed-rate residential mortgages has remained very stable over interest rate cycles.

Q: Residential mortgages are the smallest component of bank real estate loan portfolios.

Q: Commercial real estate mortgages have been the fastest growing component of real estate loans.

Q: Commercial loans have been decreasing in importance in bank loan portfolios.

Q: Commercial paper typically is secured by specific assets of the borrower.

Q: Commercial paper has become an acceptable substitute source for bank loans formany large corporations.

Q: Long-term loans are more likely to be made under a loan commitment agreement than short-term loans.

Q: The exact interest rate to be charged on a fixed-rate loan is agreed upon by all parties at the time the commitment is negotiated.

Q: A loan commitment is an agreement involving the amount of loan available and the amount of time during which the loan can be initiated.

Q: The amount of security or collateral on a loan and the interest rate or risk premium on a loan normally are negatively related.

Q: Unsecured debt is considered to be senior to secured debt.

Q: A secured loan has a claim to specific assets of the borrower in the case of default.

Q: The primary difficulty in arranging a syndicated loan is having all of the various lending and borrowing parties reach agreement on terms, rates, and collateral.

Q: Credit risk applies only to bond investment and loan portfolios of FIs and banks.

Q: Sustained credit quality problems can drain an FI's capital and net worth.

Q: During the decade of the 1990s the asset quality of U.S. banks continued to improve.

Q: Junk bonds are bonds that are rated less than investment grade by bond-rating agencies.

Q: Default by a large corporation is seldom a problem for FIs since these corporations have many different sources of borrowed funds.

Q: Use the following information and the option valuation model for the next two problems. Onyx Corporation has a $200,000 loan that will mature in one year. The risk free interest rate is 6 percent. The standard deviation in the rate of change in the underlying asset's value is 12 percent, and the leverage ratio for Onyx is 0.8 (80 percent). The value for N(h1) is 0.02743, and the value for N(h2) is 0.96406.What is the required yield on this risky loan? A. 6.165 percent.B. 6.00 percent.C. 0.165 percent.D. 5.835 percent.E. None of the above.

Q: Use the following information and the option valuation model for the next two problems. Onyx Corporation has a $200,000 loan that will mature in one year. The risk free interest rate is 6 percent. The standard deviation in the rate of change in the underlying asset's value is 12 percent, and the leverage ratio for Onyx is 0.8 (80 percent). The value for N(h1) is 0.02743, and the value for N(h2) is 0.96406.What is the current market value of the loan? A. $160,000.B. $189,932.C. $200,000.D. $188,352.E. $178,571.

Q: The duration of a soon to be approved loan of $10 million is four years. The 99th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent.If the minimum RAROC acceptable to the bank is 8 percent, what should be its expected percentage fee income in order for it to approve the loan? A. .157 percent.B. .331 percent.C. .471 percent.D. .531 percent.E. .571 percent.

Q: The duration of a soon to be approved loan of $10 million is four years. The 99th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent.What is the estimated risk-adjusted return on capital (RAROC) of this loan. A. 6.36 percent.B. 7.00 percent.C. 7.13 percent.D. 10.55 percent.E. 25.45 percent.

Q: The duration of a soon to be approved loan of $10 million is four years. The 99th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent.If the fee income on this loan is 0.4 percent and the spread over the cost of funds to the bank is 1 percent, what is the expected income on this loan for the current year? A. $40,000.B. $100,000.C. $140,000.D. $180,000.E. $280,000.

Q: The duration of a soon to be approved loan of $10 million is four years. The 99th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent.What is the capital (loan) risk of the loan if the current average level of interest rates for this category of bonds is 12 percent? A. -$550,000.B. -$1,564,280.C. -$1,964,280.D. -$2,000,000.E. -$2,200,000.

Q: The following is information on current spot and forward term structures (assume the corporate debt pays interest annually):The cumulative probability of repayment of BBB corporate debt over the next two years is A. 99.84 percent.B. 92.10 percent.C. 4.45 percent.D. 95.70 percent.E. 7.90 percent.

Q: The following is information on current spot and forward term structures (assume the corporate debt pays interest annually): Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the second year is A. 4.20 percent.B. 98.0 percent.C. 2.35 percent.D. 2.71 percent.E. 3.88 percent.

Q: The following is information on current spot and forward term structures (assume the corporate debt pays interest annually): 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.

Q: The following is information on current spot and forward term structures (assume the corporate debt pays interest annually):Calculate the value of y (the implied forward rate on one-year maturity BBB corporate debt to be delivered in one year). A. 6.53 percent.B. 10.83 percent.C. 5.75 percent.D. 6.925 percent.E. 1.017 percent.

Q: The following is information on current spot and forward term structures (assume the corporate debt pays interest annually):Calculate the value of x (the implied forward rate on one-year maturity Treasuries to be delivered in one year). A. 6.53 percent.B. 10.83 percent.C. 5.75 percent.D. 6.925 percent.E. 1.017 percent.

Q: 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: PDi = 0.5(D/Ei) + 0.1(S/Ai). If a prospective borrower has a debt-equity ratio of 0.4 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.

Q: The following information on the mortality rate of loans as estimated by an FI:If the cumulative mortality rate in year 3 is 3.46 percent for the B-rated loan, what is its yearly mortality rate in year 3? A. 1.25 percent.B. 1.21 percent.C. 1.00 percent.D. 0.90 percent.E. 0.875 percent.

Q: The following information on the mortality rate of loans as estimated by an FI:What is the cumulative mortality rate of the A-rated and B-rated loans for year 2? A. 1.0 percent and 2.24 percent.B. 0.5 percent and 1.24 percent.C. 1.0 percent and 1.74 percent.D. 0.5 percent and 0.5 percent.E. 1.0 percent and 1.0 percent.

Q: The following represents two yield curves.What is the probability that two-year B-rated corporate debt will be fully repaid? A. 92.9 percent.B. 95.6 percent.C. 97.2 percent.D. 7.10 percent.E. 4.40 percent.

Q: The following represents two yield curves.What is the expected probability of default in year 2 of two-year maturity B-rated debt? A. 2.83 percent.B. 3.00 percent.C. 4.43 percent.D. 2.68 percent.E. 5.00 percent.

Q: The following represents two yield curves.What spread is expected between the one-year maturity B-rated bond and the one-year Treasury bond in one year? A. 3.00 percent.B. 5.06 percent.C. 4.00 percent.D. 5.00 percent.E. 7.00 percent.

Q: The following represents two yield curves. What interest rate is expected on a one-year B-rated corporate bond in one year? (Hint: Use the implied forward rate.) A. 10.0 percent.B. 9.09 percent.C. 14.15 percent.D. 12.0 percent.E. 17.0 percent.

Q: The following represents two yield curves. What is the implied probability of repayment on one-year B-rated debt? A. 95.00 percent.B. 97.17 percent.C. 94.00 percent.D. 97.00 percent.E. 97.09 percent.

Q: Suppose X3 = 0.2 instead of -0.30. According to Altman's credit scoring model, the firm would fall under which default risk classification? A. A high default risk firm. B. An indeterminant default risk firm. C. A low default risk firm. D. A medium default risk firm. E. Either B or D.

Q: According to Altman's credit scoring model, this firm should be considered A. a high default risk firm. B. an indeterminant default risk firm. C. a low default risk firm. D. a lowest risk customer. E. Either C or D.

Q: Suppose that the financial ratios of a potential borrowing firm took the following values:X1 = 0.30X2 = 0X3 = -0.30X4 = 0.15X5 = 2.1Altman's discriminant function takes the form:Z = 1.2 X1+ 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5The Z score for the firm would be A. 1.64.B. 1.56.C. 2.1.D. 3.54.E. 2.96.

Q: Using a modified discriminant function similar to Altman's, Burger Bank estimates the following coefficients for its portfolio of loans:Z = 1.4X1 + 1.09X2 + 1.5X3where X1 = debt to asset ratio; X2 = net income and X3 = dividend payout ratio.Using Z = 1.682 as the cut-off rate, what should be the debt to asset ratio of the firm in order for the bank to approve the loan? A. 40.0 percent.B. 46.5 percent.C. 51.5 percent.D. 54.0 percent.E. 65.0 percent.

Q: Using a modified discriminant function similar to Altman's, Burger Bank estimates the following coefficients for its portfolio of loans:Z = 1.4X1 + 1.09X2 + 1.5X3where X1 = debt to asset ratio; X2 = net income and X3 = dividend payout ratio.What is the Z-score if the debt to asset ratio is 40 percent, net income is 12 percent, and the dividend payout ratio is 60 percent? A. 1.59.B. 1.48.C. 1.36.D. 1.28.E. 1.20.

Q: Simulations by Moody's Analytics have shown which of the following models to be relatively better predictors of corporate failure and distress? A. Z score-type models. B. S&P rating changes. C. Expected Default Frequency (EDF) models. D. Linear probability models. E. Logit models.

Q: What does the Moody's Analytics model use as equivalent to holding a call option on the assets of the firm? A. The value of equity in a firm. B. Total liabilities of a firm. C. Net income of a firm. D. Dividend yield of investments. E. Short-term debt liabilities of a firm.

Q: From the lender's point of view, debt can be evaluated as A. writing a call option on the borrower's assets with the exercise price equal to the face value of the debt. B. buying a call option on the borrower's liabilities with the exercise price equal to the market value of the debt. C. buying a put option on the borrower's assets with the exercise price equal to the face value of the debt. D. writing a put option on the borrower's assets with the exercise price equal to the face value of the debt. E. writing a put option on the borrower's liabilities with the exercise price equal to the market value of the debt.

Q: Which of the following completes the statement: All else equal, the higher the duration of a loan, A. the lower the current level of interest rates, the higher the RAROC. B. the lower the expected change in risk premium, the lower the RAROC. C. the higher the expected change in risk premium, the higher the RAROC. D. the higher the loan amount, the lower the RAROC. E. the lower the loan amount, the lower the RAROC.

Q: What is the essential idea behind RAROC? A. Evaluating the actual or contractually promised annual ROA on a loan. B. Analyzing historic or past default risk experience. C. Balancing expected interest and fee income less the cost of funds against the loan's expected risk. D. Extracting expected default rates from the current term structure of interest rates. E. Dividing net interest and fees by the amount lent.

Q: Which of the following is NOT a valid conceptual or application problem of the mortality rate approach to estimate default risk? A. Implied future probabilities are sensitive to the period over which MMRs are calculated. B. The estimates are sensitive to the number of issues in each investment grade. C. Syndicated loans seem to have higher mortality rates than corporate bonds. D. The estimated probability values are historic or backward-looking measures. E. The estimates are sensitive to the relative size of issues in each investment grade.

Q: Which of the following refers to the term "mortality rate"? A. The success rate of new investments. B. A one-period rate of interest expected on a bond issued at some date in the future. C. The probability that a borrower will default in any given year. D. Historic default rate experience of a bond or loan. E. The probability that a borrower will default over a specified multiyear period.

Q: 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.

Q: Cumulative default probability refers to A. probability that a borrower will default over a specified multiyear period. B. expected maximum change in the loan rate due to a change in the risk factor on the loan. C. historic default rate experience of a bond or loan. D. expected maximum change in the loan rate due to a change in the credit premium. E. probability that a borrower will default in any given year.

Q: Marginal default probability refers to the A. probability that a borrower will default over a specified multiyear period. B. marginal increase in the default probability due to a change in credit premium. C. historic default rate experience of a bond or loan. D. expected maximum change in the loan rate due to a change in the credit premium. E. probability that a borrower will default in any given year.

Q: Which of the following is a problem in using discriminant analysis to evaluate credit risk? A. It does not consider gradations of default. B. The weights in the discriminant function are assumed to be dynamic. C. It can include hard-to-quantify factors. D. Data on loan specific information of banks are readily available. E. It does not assume that variables are independent of one another.

Q: What is the least important factor determining bankruptcy, according to the Altman Z-score model? A. Working capital to assets ratio B. Retained earnings to assets ratio C. Earnings before interest and taxes to assets ratio D. Market value of equity to book value of long-term debt ratio E. Sales to assets ratio

Q: What is the most important factor determining bankruptcy, according to the Altman Z-score model? A. Working capital to assets ratio. B. Retained earnings to assets ratio. C. Earnings before interest and taxes to assets ratio. D. Market value of equity to book value of long-term debt ratio. E. Sales to assets ratio.

Q: How can discriminant analysis be used to make credit decisions? A. By discriminating between good and bad borrowers. B. By using statistical analysis to predict the default probabilities. C. By using statistical analysis to isolate and weight factors to arrive at default risk classification of a commercial borrower. D. By using statistical analysis to bypass qualitative credit decision making. E. By updating FI bankruptcy experiences.

Q: According to Altman's credit scoring model, which of the following Z scores would indicate a low default risk firm? A. Less than 1. B. 1. C. Between 1 and 1.81. D. Between 1.81 and 2.99. E. Greater than 2.99.

Q: Which of the following is the major weakness of the linear probability model? A. The model is based on past data of the borrower. B. Measurement of the loan risk is difficult. C. Estimated probabilities of default may lie outside the interval 0 to 1. D. Neither the market value of a firm's assets nor the volatility of the firm's assets is directly observed. E. None of the above is a weakness of the linear probability model.

Q: Which of the following is true of the prime lending rate? A. It is most commonly used in pricing longer-term loans.B. It is the lending rate charged to the FI's lowest-risk customers.C. It is also known as LIBOR.D. It is the rate for interbank dollar loans of a given maturity in the Eurodollar market.E. The best and largest borrowers commonly pay above this lending rate.

Q: Which of the following loan applicant characteristics is not relevant in the credit approval decision? A. Leverage position of the borrower. B. Borrower income. C. Value of collateral. D. Borrower reputation. E. None of the above.

Q: Borrower reputation is important in assessing credit quality because A. good past payment performance perfectly predicts future behavior. B. preservation of a good customer/FI relationship acts as an additional incentive to encourage loan repayment. C. FIs only lend to customers they know. D. customers with poor credit histories always default on their loans. E. a reputation for honesty is important in credit appraisal.

Q: In making credit decisions, which of the following items is considered a market-specific factor? A. Whether the borrower's capital structure is beyond the point where additional debt increases the probability of loss of principal or interest. B. Whether the relative level of interest rates will encourage the borrower to take excessive risks. C. Whether property can be pledged as collateral. D. Whether the volatility of earnings could present a period where the periodic payment of interest and principal would be at risk. E. Whether the record of the borrower is sufficient to create an implicit contract.

Q: Credit scoring models include all of the following broad types of models EXCEPT A. Linear discriminant models. B. Linear probability models. C. Term structure models. D. Logit models. E. None of the above.

Q: Which of the following refers to restrictions in loan and bond agreements that encourage or forbid certain actions by the borrower? A. Mortality rates. B. RAROC. C. Implicit contracts. D. Covenants. E. Credit rationing.