Chapter 10

Credit scoring models include all of the following broad types of models EXCEPT

Term structure models

Suppose that the financial ratios of a potential borrowing firm took the following values: X1 = 0.30 X2 = 0 X3 = -0.30 X4 = 0.15 X5 = 2.1 Altman's discriminant function takes the form: Z = 1.2 X1+ 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 The Z score for the firm would be

1.56 Z = 1.2(0.30) + 1.4(0.00) + 3.3(-0.30) + 0.6(0.15) + 1.0(2.1)Z = 0.36 + 0.00 - 0.99 + 0.09 + 2.1 = 1.56

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 + 1.5X3 where 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?

1.59 Z = 1.4(0.40) + 1.09(0.12) + 1.50(0.60) = 0.56 + 0.1308 + 0.90 = 1.59

Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves at the Fed are 6 percent. What is the expected or promised gross return on the loan?

12.22%

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?

46.5 percent Z = 1.4X1 + 1.09X2 + 1.5X3 1.682 = 1.4X1 + 1.09(0.12) + 1.5(0.60) 1.682 = 1.031 + 1.4X1 (1.682 - 1.031) ÷ 1.4 = X1 = 0.465

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

8 percent.

Which of the following statements does not reflect a borrower-specific factor often used in qualitative default risk models?

A borrower's leverage ratio is positively related to the probability of default over all levels of debt.

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 low default risk firm Z = 1.2(0.30) + 1.4(0.00) + 3.3(0.20) + 0.6(0.15) + 1.0(2.1) Z = 0.36 + 0.00 + 0.66 + 0.09 + 2.1 = 3.21

Which of the following is NOT characteristic of the real estate portfolio for most banks?

Borrowers prefer fixed-rate loans to ARMs during periods of high interest rates.

What is the most important factor determining bankruptcy, according to the Altman Z-score model?

Earnings before interest and taxes to assets ratio.

Which of the following is the major weakness of the linear probability model?

Estimated probabilities of default may lie outside the interval 0 to 1.

From the lender's point of view, debt can be evaluated as

writing a put option on the borrower's assets with the exercise price equal to the face value of the debt.

What is the least important factor determining bankruptcy, according to the Altman Z-score model?

Market value of equity to book value of long-term debt ratio

According to Altman's credit scoring model, which of the following Z scores would indicate a low default risk firm?

Greater than 2.99.

Which of the following refers to the term "mortality rate"?

Historic default rate experience of a bond or loan.

Which of the following is true of the prime lending rate?

It is most commonly used in pricing longer-term loans.

Which of the following is true of commercial paper?

It may help a corporation to raise funds often at rates below those banks charge.

Which of the following statements does NOT reflect credit decisions at the retail level?

Loans to retail customers are more likely to be rationed through interest rates than loan quantity restrictions.

Which of the following is NOT a valid conceptual or application problem of the mortality rate approach to estimate default risk?

Syndicated loans seem to have higher mortality rates than corporate bonds.

Which of the following is not a characteristic of a loan commitment?

The interest rate on fixed-rate loans is determined at the time of the load is actually taken down.

From the perspective of an FI, which of the following is an advantage of a floating-rate loan?

The interest rate risk is transferred to the borrower.

What does the Moody's Analytics model use as equivalent to holding a call option on the assets of the firm?

The value of equity in a firm.

Which of the following observations concerning floating-rate loans is NOT true?

They have less credit risk than fixed-rate loans.

All other things equal, longer term loans are more likely to be

Variable-rate loans.

Which of the following factors may affect the promised return an FI receives on a loan?

A. The collateral backing of the loan. B. Fees relating to the loan. C. The interest rate on the loan. D. The credit risk premium on the loan.

Cumulative default probability refers to

probability that a borrower will default over a specified multiyear period.

What is the essential idea behind RAROC?

Balancing expected interest and fee income less the cost of funds against the loan's expected risk.

Which of the following is not a qualitative factor in credit risk analysis?

Borrower ethnic origin.

How can discriminant analysis be used to make credit decisions?

By using statistical analysis to isolate and weight factors to arrive at default risk classification of a commercial borrower.

Which of the following statements involving the promised return on a loan is NOT true?

Compensating balances reduce the effective cost of loans for the borrower because the deposit interest rate is typically greater than the loan rate.

Which of the following refers to restrictions in loan and bond agreements that encourage or forbid certain actions by the borrower?

Convenants

What refers to the risk that the borrower is unable or unwilling to fulfill the terms promised under the loan contract?

Default risk

Simulations by Moody's Analytics have shown which of the following models to be relatively better predictors of corporate failure and distress?

Expected Default Frequency (EDF) models

Which of the following completes the statement: All else equal, the higher the duration of a loan,

the higher the loan amount, the lower the RAROC.

Which of the following is a problem in using discriminant analysis to evaluate credit risk?

It does not consider graduations of default.

Which of the following observations is true of a spot loan?

It involves immediate withdrawal of the entire loan amount by the borrower.

Which of the following loan applicant characteristics is not relevant in the credit approval decision?

None of the above.

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

PDi = 0.5(D/Ei) + 0.1(S/Ai) = 0.50(0.40) + 0.10(1.80) = 0.2 + 0.18 = 0.38

Which of the following is NOT characteristic of the consumer loans at U.S. banks?

Revolving consumer loans include new and used automobile loans, mobile home loans, and fixed-term consumer loans.

In making credit decisions, which of the following items is considered a market-specific factor?

Whether the position of the economy in the business cycle phase would affect the probability of borrower default.

In making credit decisions, which of the following items is considered a market-specific factor?

Whether the relative level of interest rates will encourage the borrower to take excessive risks.

According to Altman's credit scoring model, this firm should be considered

a high default risk firm

Credit rationing by an FI

involves restricting the quantity of loans made available to individual borrowers.

Revolving loans are credit lines

on which a borrower can both draw and repay many times over the life of the loan contract.

Borrower reputation is important in assessing credit quality because

preservation of a good customer/FI relationship acts as an additional incentive to encourage loan repayment.

Marginal default probability refers to the

probability that a borrower will default in any given year.