Question 1

The condition of no arbitrage profits implies that profits cannot be made without taking some risk.

Accepted Answer

A) True 
 B)False  True

Question 2

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

Accepted Answer

A) True 
 B)False  True

Question 3

Marginal default probability refers to the

Accepted Answer

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. 
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. E

Question 4

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

Accepted Answer

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. 
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.

Question 5

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

Accepted Answer

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

Question 6

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

Accepted Answer

A) Credit risk may be the most important factor affecting the return on a loan. 
B) 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 balances represents the portion of the loan that must be kept on deposit at the bank. 
D) Compensating balance requirements provide an additional source of return for the lending institution. 
E) Increased collateral is a method of compensating for lending risk. 
A) Credit risk may be the most important factor affecting the return on a loan. 
B) 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 balances represents the portion of the loan that must be kept on deposit at the bank. 
D) Compensating balance requirements provide an additional source of return for the lending institution. 
E) Increased collateral is a method of compensating for lending risk.

Question 7

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?

Accepted Answer

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

Question 8

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.

Accepted Answer

A) 6.36 percent. 
B) 7.00 percent. 
C) 7.13 percent. 
D) 10.55 percent. 
E) 25.45 percent. 
A) 6.36 percent. 
B) 7.00 percent. 
C) 7.13 percent. 
D) 10.55 percent. 
E) 25.45 percent.

Question 9

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

Accepted Answer

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

Question 10

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

Accepted Answer

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 
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

Question 11

One of the problems with estimating expected default rates is that the analysis is based on historic data.

Accepted Answer

A) True 
 B)False

Question 12

The following represents two yield curves. $$\begin{array} { | l | c | c | } 
\hline \text { Maturity } & \begin{array} { c } 
\text { Pure Discount } \
\text { Treasury Yields }
\end{array} & \begin{array} { c } 
\text { B-rated Corporate Bond Yields } \
\text { (Pure Discount Bonds) }
\end{array} \
\hline 1 \text { year } & 3 \text { percent } & 6 \text { percent } \
\hline 2 \text { year } & 6 \text { percent } & 10 \text { percent } \
\hline 20 \text { year } & 12 \text { percent } & 17 \text { percent } \
\hline
\end{array}$$
-What spread is expected between the one-year maturity B-rated bond and the one-year Treasury bond in one year?

Accepted Answer

A) 3.00 percent. 
B) 5.06 percent. 
C) 4.00 percent. 
D) 5.00 percent. 
E) 7.00 percent. 
A) 3.00 percent. 
B) 5.06 percent. 
C) 4.00 percent. 
D) 5.00 percent. 
E) 7.00 percent.

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

The following is information on current spot and forward term structures (assume the corporate debt pays interest annually): $$\begin{array} { | l | l | l | c | } 
\hline & \text { Spot 1 Year } & \text { Spot 2 Year } & \begin{array} { l } 
\text { (1-year maturity) } \
\text { Forward 1-year }
\end{array} \
\hline \text { Treasury } & 3.0 \text { percent } & 4.75 \text { percent } & \mathrm { X } \
\hline \text { BBB Corporate Debt } & 7.5 \text { percent } & 9.15 \text { percent } & \mathrm { Y } \
\hline
\end{array}$$
-Calculate the value of x (the implied forward rate on one-year maturity Treasuries to be delivered in one year).

Accepted Answer

A) 6.53 percent. 
B) 10.83 percent. 
C) 5.75 percent. 
D) 6.925 percent. 
E) 1.017 percent. 
A) 6.53 percent. 
B) 10.83 percent. 
C) 5.75 percent. 
D) 6.925 percent. 
E) 1.017 percent.

Question 15

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

Accepted Answer

A) Z score-type models. 
B) S&P rating changes. 
C) Expected Default Frequency (EDF) models. 
D) Linear probability models. 
E) Logit models. 
A) Z score-type models. 
B) S&P rating changes. 
C) Expected Default Frequency (EDF) models. 
D) Linear probability models. 
E) Logit models.

Question 16

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

Accepted Answer

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. 
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.

Question 17

Revolving loans are credit lines

Accepted Answer

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

Question 18

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

Accepted Answer

A) True 
 B)False

Question 19

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.

Accepted Answer

A) True 
 B)False

Question 20

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

Accepted Answer

A) True 
 B)False

Exam 10: Credit Risk: Individual Loan Risk

The condition of no arbitrage profits implies that profits cannot be made without taking some risk.

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

Marginal default probability refers to the

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

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

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

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.

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

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

One of the problems with estimating expected default rates is that the analysis is based on historic data.

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

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

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

Revolving loans are credit lines

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

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.

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

Why Are Financial Institutions Special

Financial Services: Depository Institutions

Financial Services: Finance Companies

Financial Services: Securities Brokerage and Investment Banking

Financial Services: Mutual Funds and Hedge Funds

Financial Services: Insurance

Risks of Financial Institutions

Interest Rate Risk I

Interest Rate Risk II

Credit Risk: Loan Portfolio and Concentration Risk

Liquidity Risk

Foreign Exchange Risk

Sovereign Risk

Market Risk

Off-Balance-Sheet Risk

Technology and Other Operational Risks

Liability and Liquidity Management

Deposit Insurance and Other Liability Guarantees

Capital Adequacy

Product and Geographic Expansion

Futures and Forwards

Options, Caps, Floors, and Collars

Swaps

Loan Sales

Securitization

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