FIN 440 Ch. 10

Suppose that the financial ratios of a potential borrowing firm took the following values :X 1 = 0.30 X 2 = 0 X 3 = -0.30 X 4 = 0.15 X 5 = 2.1 Altman's discriminant function takes the form:Z = 1.2 X 1+ 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 1.0 X 5 Suppose X 3 = 0.2 instead of -0.30. According to Altman's credit scoring model, the firm would fall under which default risk classification? A) A low default risk firm. B) An indeterminant default risk firm. C) A high default risk firm. D) A medium default risk firm. E) Either B or D.

A) A low default risk firm.

What refers to the risk that the borrower is unable or unwilling to fulfill the terms promised under the loan contract? A) Default risk. B) Solvency risk. C) Interest rate risk. D) Sovereign risk. E) Liquidity risk.

A) Default risk.

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 1.0 percent. D) 0.5 percent and 0.5 percent. E) 1.0 percent and 1.74 percent.

A) 1.0 percent and 2.24 percent. Response Feedback:A-rated loans Cp = (1 − p1) × (1 − p2) = (1 − 0.005) × (1 − 0.005) = (0.995) × (0.995) = 0.9900 So cumulative mortality rate: (1 − Cp) = 1 − 0.990 = 0.01 B-rated loans Cp = (1 − p1) × (1 − p2) = (1 − 0.01) × (1 − 0.0125) = (0.99) × (0.9875) = 0.9776 So cumulative mortality rate: (1 − Cp) = 1 − 0.9776 = 0.0224

What is the implied probability of repayment on one-year B-rated debt? A) 97.17 percent. B) 97.00 percent. C) 95.00 percent. D) 97.09 percent. E) 94.00 percent.

A) 97.17 percent. Response Feedback: p(1 + k) = (1 + i) p = (1 + i) ÷ (1 + k) where p = probability of full repayment k = interest rate on corporate debt i = interest rate on Treasury p1 = (1.03) ÷ (1.06) = 0.9717 probability of default = (1 − p1) = 1 − 0.9717 = 0.0283

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) 10 percent. B) 11 percent. C) 18 percent. D) 9 percent. E) 8 percent.

E) 8 percent.

Which of the following factors may affect the promised return an FI receives on a loan? A) The collateral backing of the loan. B) The credit risk premium on the loan. C) The interest rate on the loan. D) Fees relating to the loan. E) All of the options.

E) All of the options.

Which of the following is NOT characteristic of the real estate portfolio for most banks? A) Commercial real estate mortgages have been the fastest growing component of real estate loans. B) Adjustable rate mortgages have rates that are periodically adjusted to some index. C) Residential mortgages are the largest component of the real estate loan portfolio. D) The proportion of ARMs to fixed-rate mortgages can vary considerably over the rate cycle. E) Borrowers prefer fixed-rate loans to ARMs during periods of high interest rates.

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

Which of the following observations is true of a spot loan? A) It is a nonbank loan substitute. B) It involves a maximum size and a maximum period of time over which the borrower can withdraw funds. C) It is an unsecured short-term debt instrument issued by corporations. D) It is a line of credit. E) It involves immediate withdrawal of the entire loan amount by the borrower.

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

Which of the following is true of commercial paper? A) All corporations can tap the commercial paper market. B) It is always issued via an underwriter. C) It is a secured long-term debt instrument issued by corporations. D) Total commercial paper outstanding in the US is smaller than total C&I loans. E) It may help a corporation to raise funds often at rates below those banks charge

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

Which of the following is not a characteristic of a loan commitment? A) The time period for which the loan is available is negotiated at the time of the loan agreement. B) In a floating-rate loan the borrower pays interest rate in force when the loan is actually taken down. C) Floating-rate loans transfer the interest rate risk to the borrower. D) The maximum amount of the loan is negotiated at the time of the loan agreement. E) The interest rate on fixed-rate loans is determined at the time of the loan is actually taken down.

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

Using a modified discriminant function similar to Altman's, Burger Bank estimates the following coefficients for its portfolio of loans: Z = 1.4X 1 + 1.09X 2 + 1.5X 3 where X 1 = debt to asset ratio; X 2 = net income and X 3 = 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) 1.48. B) 1.20. C) 1.28. D) 1.59. E) 1.36.

D) 1.59. Response Feedback: 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? A) 11.90 percent. B) 12.02 percent. C) 12.29 percent. D) 12.22 percent. E) 11.19 percent.

D) 12.22 percent.

Revolving loans are credit lines A) whose interest rate adjusts with movements in an underlying market index interest rate. B) that specify a maximum size and a maximum period of time over which the borrower can withdraw funds. C) that include new and used automobile loans, mobile home loans, and fixed-term consumer loans. D) on which a borrower can both draw and repay many times over the life of the loan contract. E) that allow the borrower to borrow the repeat credit only after the first loan is repaid.

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

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

All other things equal, longer term loans are more likely to be A) fixed-rate loans. B) high interest rate loans. C) lowest risk category loans. D) variable-rate loans. E) commitment loans.

D) variable-rate loans.

A borrower's reputation is an example of a market-specific factor in the credit decision. True/False

False

Because they are secured by homes, residential mortgages have demonstrated very little credit risk for FIs. True/False

False

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

False

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. True/False

False

Since their introduction, the proportion of adjustable rate mortgages (ARMs) to fixed-rate residential mortgages has remained very stable over interest rate cycles. True/False

False

Unsecured debt is considered to be senior to secured debt. True/False

False

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. True/False

True

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.

True

Commercial loans have been decreasing in importance in bank loan portfolios. True/False

True

Commercial paper has become an acceptable substitute source for bank loans for many large corporations. True/False

True

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

True

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

True

Credit rationing is a form of managing credit risk. True/False

True

Credit scoring models are advantageous because of their ability to sort borrowers into different default risk classes. True/False

True

Discriminant models often ignore hard-to-quantify factors in the credit decision.

True

Junk bonds are bonds that are rated less than investment grade by bond-rating agencies. True/False

True

One of the weaknesses of estimating expected default rates is that the analysis is based on historic data. True/False

True

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

True

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

True

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. True/False

True

The probability that a borrower would default in any specific time period is the marginal default probability. True/False

True

The risk premium, or spread, between corporate bonds and Treasury securities tends to increase as the time to maturity increases. True/False

True

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) 0.62. B) 0.38. C) 0.02. D) 0.98. E) 0.35.

B) 0.38. Response Feedback: PDi = 0.5(D/Ei) + 0.1(S/Ai) = 0.50(0.40) + 0.10(1.80) = 0.2 + 0.18 = 0.38

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

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

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

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

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) -$2,000,000. C) -$1,964,280. D) -$2,200,000. E) -$1,564,280.

C) -$1,964,280.

Suppose that the financial ratios of a potential borrowing firm took the following values: X 1 = 0.30 X 2 = 0 X 3 = -0.30 X 4 = 0.15 X 5 = 2.1 Altman's discriminant function takes the form:Z = 1.2 X 1+ 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 1.0 X 5 The Z score for the firm would be A) 3.54. B) 2.96. C) 1.56. D) 1.64. E) 2.1.

C) 1.56. Response Feedback: 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

Which of the following statements does not reflect a borrower-specific factor often used in qualitative default risk models? A) Firms with high earnings variance are less attractive credit risks than those firms that have a history of stable earnings. B) Loans can be collateralized or uncollateralized. C) A borrower's leverage ratio is positively related to the probability of default over all levels of debt. D) Reputation is a key reason why initial public offering of debt securities by small firms have a higher interest rate than do debt issues of more seasoned borrowers. E) Reputation is an implicit contract regarding borrowing and repayment that extends beyond the formal explicit legal contract.

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

Which of the following statements involving the promised return on a loan is NOT true? A) Increased collateral is a method of compensating for lending risk. C) Compensating balances reduce the effective cost of loans for the borrower because the deposit interest rate is typically greater than the loan rate. C) Compensating balance requirements provide an additional source of return for the lending institution. D) Credit risk may be the most important factor affecting the return on a loan. E) Compensating balances represents the portion of the loan that must be kept on deposit at the bank.

C) 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? A) RAROC. B) Implicit contracts. C) Covenants. D) Credit rationing. E) Mortality rates.

C) Covenants.

Which of the following statements does NOT reflect credit decisions at the retail level? A) Mortgage loans often are discriminated based on loan to price ratios rather than interest rates. B) Retail loans tend to be smaller than wholesale loans. C) Loans to retail customers are more likely to be rationed through interest rates than loan quantity restrictions. D) Household borrowers require higher costs of information collection for lenders. E) Most loan decisions at the retail level tend to be accept or reject decisions.

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

Which of the following is NOT characteristic of the consumer loans at U.S. banks? A) Consumer loans differ widely with respect to collateral, rates, maturity, and noninterest fees. B) Credit card loans often have default rates between four and eight percent. C) Revolving consumer loans include new and used automobile loans, mobile home loans, and fixed-term consumer loans. D) Usury ceilings affect the rate structure for consumer loans. E) Non revolving consumer loans is the largest class of loans.

C) 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? A) Whether the volatility of earnings could present a period where the periodic payment of interest and principal would be at risk. B) Whether the reputation of the borrower enhances the credit application. C) Whether the position of the economy in the business cycle phase would affect the probability of borrower default. D) Whether the debt can be secured by specific property. E) Whether the current debt-equity ratio is sufficiently low to not impact the probability of repayment.

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

Suppose that the financial ratios of a potential borrowing firm took the following values: X 1 = 0.30 X 2 = 0 X 3 = -0.30 X 4 = 0.15 X 5 = 2.1 Altman's discriminant function takes the form:Z = 1.2 X 1+ 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 1.0 X 5 According to Altman's credit scoring model, this firm should be considered A) a lowest risk customer. B) a low default risk firm. C) a high default risk firm. D) an indeterminant default risk firm. E) Either C or D.

C) a high default risk firm.

Credit rationing by an FI A) involves rationing consumer loans using price or interest rate differences. B) is not used by FIs at the retail level. C) involves restricting the quantity of loans made available to individual borrowers. D) is only relevant to banks. E) results from a positive linear relationship between interest rates and expected loan returns.

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

A loan commitment is an agreement involving the amount of loan available and the amount of time during which the loan can be initiated. True/False

True

A secured loan has a claim to specific assets of the borrower in the case of default. True/False

True