MBFI

Problem set # 2

Chapter 10
Q23
a.
Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
X1 = = Working capital/total assets (TA) = (20+90+90-30-90-30) / 700 = .0714 X1
X2 = Retained earnings/TA = 22 / 700 = .0314
X3 = EBIT/TA = (500-360) / 700 = .20
X4 = Market value of equity/Book value of long-term debt
= 400 / 150 = 2.6667
X5 = Sales/TA = 500 / 700 = .7143
Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(0.20) + 0.6(2.6667) + 1.0(0.7143) = 3.104
= .0857 + .0440 + .6600 + 1.600 + .7143 = 3.104

Since Z score > 2.99, the firm’s risk of default is low.

b. A capital expenditure loan of $500,000 will result in the following balance sheet:

Assets Liabilities and Equity

Cash $ 20 Accounts payable $ 30
Accounts receivables 90 Notes payable 90
Inventory 90 Accruals 30
Long-term debt 650
Plant and equipment 1000 Equity (ret. earnings = $22) 400
Total assets $1200 Total liabilities and equity $1200

Assuming this to be a project with a longer gestation period so sales and earnings will not change
for a year:
X1 = 0.042
X2 = 0.018
X3 = 0.117
X4 = 0.615
X5 = 0.417
Z Score = 1.25
Since the Z Score is below 1.81, the default risk is high. Additional loan of $500,00 should not
be given.

c. If sales is $300,000 and market value of equity is $200,000 (assuming all other values are as in
part a):
Z Score = 0.9434
Since the Z score is below 1.81, the risk of default is high. Credit should be denied.
d. Discriminant function models are very sensitive to the weights for the different variables.
Since different industries have different operating characteristics, a reasonable answer would be
yes with the condition that there is no reason that the functions could not be similar for different
industries. In the retail market, the demographics of the market play a big role in the value of the
weights. For example, credit card companies often evaluate different models for different areas
of the country. Because of the sensitivity of the models, extreme care should be taken in the
process of selecting the correct sample to validate the model for use.

Q25
a. One-year AA-rated bond yielding 9.5 percent.
Probability of repayment = p = (1 + i)/(1 + k)
For an AA-rated bond = (1 + .06)/ (1 + .095) = 0.968, or 96.80 percent

The market determined risk premium is 0.095 – 0.060 = 0.035 or 3.5 percent

b. One-year BB-rated bond yielding 13.5 percent.

Probability of repayment = p = (1 + i)/(1 + k)

For BB-rated bond = (1 + .06)/(1 + .135) = 93.39 percent

The market determined risk premium is 0.135 – 0.060 = 0.075 or 7.5 percent

Q26.
E(r) = p(1 + k) + (1 - p)(1 + k)(γ) where γ is the percentage generated when the loan is defaulted.
E(r) = .95(1 + .10) + .05(1 + .10)(.50) = 1.0450 + .0275 = 1.0725 - 1.0 = 7.25%

Q27.
a. p(1 + k) +  (1 - p)(1 + k) = 1 + i. Solve for the probability of repayment (p):

1+ i
−  1.055 − 0.5
1+ k
p= = 1.085 = 0.9447 or 94.47percent
1−  1 − 0.5

Therefore the probability of default is 1.0 - .9447 = 0.0553 or 5.53 percent.

b.

1+ i
−  1.055 − 0.9447
1+ k
p= = 1.085 = 0.5000 or 50.00percent
1−  1 − 0.9447
 c. The proportion of the loan’s principal and interest that is collectible on default is a
perfect substitute for the probability of repayment should such defaults occur.

Q31.
Treasury BBB rated bond
1 year forward rate in year 2 7.21% 9.41%
1 year forward rate in year 3 8.82% 11.53%

Using the implied forward rates, estimate the annual marginal probability of repayment:

p1(1.07) = 1.05 => p1 = 98.13 percent

p2(1.0941) = 1.0721 => p2 = 97.99 percent
p3 (1.1153) = 1.0882 => p3 = 97.57 percent

Using marginal probabilities, estimate the cumulative probability of default:

Cp2 = 1 - (p1)(p2)
= 1 - (.9813)(.9799) = 3.84 percent
Cp3 = 1 - (p1)(p2)(p3)
= 1 - (.9813)(.9799)(.9757) = 6.18 percent

Chapter 11:

Q5.
Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate);
25 percent = 2 percent x 1/Loss rate  Loss rate = 0.02/0.25 = 8 percent

Q24.
a. What is the present value of the loan at the end of the one-year risk horizon for the case
where the borrower has been upgraded from BB to BBB?

$7m $7m $7m $107m

PV = $7m + + 2
+ + = $113.27 million
1.0372 (1.0436) (1.0491) (1.0530) 4
3

b. What is the mean (expected) value of the loan at the end of year one?

Mean value = $108.06.

 c. What is the volatility of the loan value at the end of the year?

The volatility or standard deviation of the loan value is $4.19.

d. Calculate the 5 percent and 1 percent VARs for this loan assuming a normal
distribution of values.

The 5 percent VAR is 1.65 x $4.19 = $6.91.

The 1 percent VAR is 2.33 x $4.19 = $9.76.

e. Estimate the “approximate” 5 percent and 1 percent VARs using the actual distribution
of loan values and probabilities.

5% VAR = 95% of actual distribution = $108.06m - $98.43m = $9.63m

1% VAR = 99% of actual distribution = $108.06m - $86.82m = $21.24m

where: 5% VAR is approximated by 0.056 + 0.009 + 0.002 = 0.067 or 6.7 percent, and
1% VAR is approximated by 0.009 + 0.002 = 0.011 or 1.1 percent.

Using linear interpolation, the 5% VAR = $10.65 million and the 1% VAR = $19.31
million. For the 1% VAR, $19.31m = (1 – 0.1/1.1) x $21.24m.

f. How do the capital requirements of the 1 percent VARs calculated in parts (d) and (e)
above compare with the capital requirements of the BIS and Federal Reserve System?

The Fed and BIS systems would require 8 percent of the loan value, or $8 million. The 1
percent VAR would require $19.31 million under the approximate method, and $9.76
million (2.33 x $4.19m) in capital under the normal distribution assumption. In each case,
the amounts exceed the Fed/BIS amount.

Chapter 20:

Q11.
Under Basel III, depository institutions must calculate and monitor four capital ratios: common
equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based
capital ratio, and Tier I leverage ratio.

i) Common equity Tier I risk-based capital ratio = Common equity Tier I capital/credit risk-adjusted assets

ii) Tier I risk-based capital ratio =

Tier I capital (Common equity Tier I capital + additional Tier I capital)/credit risk-adjusted assets

iii) Total risk-based capital ratio = Total capital (Tier I + Tier II)/credit risk-adjusted assets,

iv) Tier I leverage ratio = tier I capital / total exposure.

Q18

a. What is the CETI risk-based ratio?

Risk-adjusted assets = $20x0.0 + $40x0.0 + $600x0.5 + $430x1.0 = $730.

CETI capital ratio = ($40 + $45)/$730 = 11.64 percent.

b. What is Tier 1 risk-based capital ratio?

Tier I capital = (40+45)/730 = 11.64%

c. What is the total risk-based capital ratio?

The total risk-based capital ratio = ($40 + $45 + $25)/$730 = 0.1507 or 15.07 percent.

d. What is the leverage ratio?

The leverage ratio is ($40 + $45)/$1,090 = 0.078 or 7.8 percent.

e. In what capital risk category would the bank be placed?

The bank would be place in the well-capitalized category.

Q28
a. What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel
Accord?

Risk-adjusted assets:
Cash 0 x 20 = $0
OECD interbank deposits 0.20 x 25 = $5
Mortgage loans 0.50 x 70 = $35
Consumer loans 1.00 x 70 = $70
Total risk-adjusted assets = $110 = $110

b. What is the total capital required for both off- and on-balance-sheet assets?

Standby LCs: $30 x 0.50 x 1.0 = $15 = $15

Foreign exchange contracts:
Potential exposure $40 x 0.05 = $2
Current exposure in the money = $0

Interest rate swaps:

Potential exposure $300 x 0.015 = $4.5
Current exposure Out-of-the money = $2
= $8.5 x 1.0 = $8.5
 Total risk-adjusted on- and off-balance-sheet assets = $133.50
x 0.08
Total capital required = $10.68

To be adequately capitalized:
CET1 Risk based ratio >= 4.5% ➔ Minimum CET1 = $6.01million
Tier I Risk based ratio >= 6% ➔ Minimum Tier I capital = $8.01m

c. Does the bank have enough capital to meet the Basel requirements? If not, what
minimum Tier 1 or total capital does it need to meet the requirement?

No, the bank does not have sufficient total capital to meet the Basel requirements. It needs
total CET1 of $6.01 million to have adequate common equity capital. Also, Tier I capital
should be atleast $8.01 million.

d. As per the Basel III phase-in, Capital conservation buffer should be 1.875% by 2018 and
2.5% by January 1, 2019. Capital conservation buffer should also be held in the form of
CET1 capital.

Chapter 26:
Q11
a. The monthly mortgage payment,
PMT, is (the monthly interest rate is .10/ 12 = .00833):
$20m = PVAn=360, k=0.8333 x (PMT)  PMT = $175,514.31

b.
The GNMA's annual interest rate is 0.10 - 0.0044 - 0.0006 = 9.5 percent. The monthly
interest rate is 0.095/12 = 0.0079167 or 0.79167 percent.

c.
The monthly GNMA payment, PMT, is: $20m = PVAn=360, k=0.79167% x PMT  PMT =
$168,170.84

d. The first monthly servicing fee,

SF, is (the monthly fee rate is .44%/12 = .0367%):
SF = (.000367)$20m = $7,333.

e.
The first monthly insurance payment, IP, is (monthly insurance rate is .06%/12 = .005%):
IP = (.00005)$20m = $1,000
Q18:

The annual mortgage payment is $60 million = PVAn=15, k=10% x PMT => PMT = $7,888,426.61.
Annual mortgage payments, with no prepayments, can be decomposed into principal and interest
payments (in millions of $s):

Interest Principal Remaining

Year Balance Payment Payment Payment Principal
1 $60.000 $7.888 $6.000 $1.888 $58.112
2 58.112 7.888 5.811 2.077 56.034
3 56.034 7.888 5.603 2.285 53.749
4 53.749 7.888 5.375 2.513 51.236

The principal outstanding at the end of the fourth year, without prepayments, is $51,235,812.10.
However, at the end of the third year, half of the mortgages in the mortgage pool are completely
prepaid. That is, at the end of the third year, an additional principal payment of 50% x
$53,749,307.92 = $26,874,653.96 is received for a remaining outstanding principal balance of
$26.875 million. The total third year principal payment is therefore $29.16 million = the regular
principal payment of $2.285 million plus an extra payment of $26.875 million.

The fourth year annual interest payment is 10% x $26.875 million = $2.687 million, leaving a
regular fourth year principal payment of $7.888 million - $2.687 million = $5,200,961.21. This
end-of-fourth-year principal payment would have left an outstanding principal balance of
$21,673,692.75, which is paid in full at the end of the year. Fourth year principal payments total
$26.875 million = $5.201 million, plus $21.674 million.

Prepayments alter the annual cash flows for years 3 and 4 as follows (in millions of $s):

Year Balance Payment Interest Principal Balance

3 56.034 7.888 5.603 29.160 26.875
4 26.875 7.888 2.687 26.875 0

Calculating the weighted average life:

Time Expected Principal Payments Time x Principal
1 1.888m 1.888
2 2.077m 4.154
3 29.160m 87.48
4 26.875m 107.5
60.000m 201.022
WAL = 201.022/60 = 3.35 years
Additional question:
CDS Prob of defaulting in 5 years 25%
Let p be prob of defaulting in any 6 months
Prob of not defaulting in 5 years 75%
(1-p)^(5 x 2) = 75%
1-p = 97.16%
prob of defaulting in any 6 month period 2.84%

Risk
Time Exp. Exp. Fee free PV of cost PV of
Prob. Of Cost to Cost to payment rates of default fee
default Seller seller to Seller payment
6
months 2.84% 80 2.2686 f 5.00% 2.21 1.00 f
12
months 2.76% 80 2.2043 f*(1-2.84%) 5.00% 2.10 0.95 f
18
months 2.68% 80 2.1418 f*(1-2.84%)^2 5.00% 1.99 0.90 f
24
months 2.60% 80 2.0810 f*(1-2.84%)^3 5.00% 1.89 0.85 f
8.19 3.70 f

By equating 8.19 = 3.70 x f, we get fee, f = 2.21