Chapter 10 Possible Exam Questions (Study Version)

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 A) 1.56. B) 1.64. C) 2.96. D) 2.1. E) 3.54.

A) 1.56.

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

A) 8 percent.

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

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

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

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

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

A) Greater than 2.99.

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

A) Historic default rate experience of a bond or loan.

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

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

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) Net income of a firm. C) Total liabilities of a firm. D) Short-term debt liabilities of a firm. E) Dividend yield of investments.

A) The value of equity in a firm.

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

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

From the perspective of an FI, which of the following is an advantage of a floating-rate loan? A) Stable interest payments will be received throughout the loan period. B) The interest rate risk is transferred to the borrower. C) The bank can request repayment of a loan at any time in the contract period. D) The pre-specified interest rate remains in force over the loan contract period no matter what happens to market interest rates. E) The default risk is completely eliminated.

B) The interest rate risk is transferred to the borrower.

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

A) 0.38. .5(.4)+.1(1.8)=.38

Which of the following is not a qualitative factor in credit risk analysis? A) Borrower ethnic origin. B) Borrower reputation. C) Collateral available. D) The level of interest rates. E) Leverage position of the borrower.

A) Borrower ethnic origin.

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. 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) 65.0 percent. D) 54.0 percent. E) 51.5 percent.

B) 46.5 percent.

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) An indeterminant default risk firm. B) A low default risk firm. C) A medium default risk firm. D) A high default risk firm. E) Either B or D.

B) A low default risk firm.

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

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

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) Estimated probabilities of default may lie outside the interval 0 to 1. C) Measurement of the loan risk is difficult. 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.

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

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

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

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

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

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? A) 1.36. B) 1.48. C) 1.59. D) 1.20. E) 1.28.

C) 1.59.

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

C) Covenants.

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

C) Expected Default Frequency (EDF) models.

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

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

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

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

In making credit decisions, which of the following items is considered a market-specific factor? A) Whether the debt can be secured by specific property. B) Whether the position of the economy in the business cycle phase would affect the probability of borrower default. 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 current debt-equity ratio is sufficiently low to not impact the probability of repayment. E) Whether the reputation of the borrower enhances the credit application.

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

B) a high default risk firm.

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

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

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

B) probability that a borrower will default in any given year.

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

B) the higher the loan amount, the lower the RAROC.

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

B) variable-rate loans.

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 record of the borrower is sufficient to create an implicit contract. C) Whether the relative level of interest rates will encourage the borrower to take excessive risks. D) Whether the volatility of earnings could present a period where the periodic payment of interest and principal would be at risk. E) Whether property can be pledged as collateral.

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

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

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

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) The proportion of ARMs to fixed-rate mortgages can vary considerably over the rate cycle. C) Residential mortgages are the largest component of the real estate loan portfolio. D) Borrowers prefer fixed-rate loans to ARMs during periods of high interest rates. E) Adjustable rate mortgages have rates that are periodically adjusted to some index.

D) 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? A) Retained earnings to assets ratio. B) Market value of equity to book value of long-term debt ratio. C) Working capital to assets ratio. D) Earnings before interest and taxes to assets ratio. E) Sales to assets ratio.

D) Earnings before interest and taxes to assets ratio.

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) Non revolving consumer loans is the largest class of loans. D) Revolving consumer loans include new and used automobile loans, mobile home loans, and fixed-term consumer loans. E) Usury ceilings affect the rate structure for consumer loans.

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

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

D) Term structure models.

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

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) 12.02 percent. B) 11.19 percent. C) 11.90 percent. D) 12.29 percent. E) 12.22 percent.

E) 12.22 percent.

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

E) All of the above.

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

E) Default risk.

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

E) It does not consider gradations of default.

Which of the following is true of commercial paper? A) All corporations can tap the commercial paper market. B) Total commercial paper outstanding in the US is smaller than total C&I loans. C) It is a secured long-term debt instrument issued by corporations. D) It is always issued via an underwriter. 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 loan applicant characteristics is not relevant in the credit approval decision? A) Borrower income. B) Borrower reputation. C) Value of collateral. D) Leverage position of the borrower. E) None of the above.

E) None of the above.

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

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

Which of the following observations concerning floating-rate loans is NOT true? A) In rising interest rate environments, borrowers may find themselves unable to pay the interest on their floating-rate loans. B) They pass the risk of interest rate changes onto borrowers. C) They better enable FIs to hedge the cost of rising interest rates on liabilities. D) The loan rate can be periodically adjusted according to a formula. E) They have less credit risk than fixed-rate loans.

E) They have less credit risk than fixed-rate loans.

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

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

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

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