Interest and Linear Probability Model Essay

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ACFI341-Finance and Markets Dr. Chris Florackis

Topic Credit Risk I
Thursday, Feb. 28th , 2013

Credit Risk

“Traditionally, organisations have viewed risk management as a corporate requirement, and have often grouped it with audit and regulatory functions” “Emphasis on reviewing reports from rating agencies, which suggests that risk management was viewed more as the hedging of certain risks and the overall outsourcing of critical risk analysis, especially as related to credit risk”

“The recent economic downturn has shown a new face and place for risk management” , FT, January 29 2009

Credit Risk

Many risk managers have pondered how the traditional risk management models failed to predict the crisis. Credit Quality Problems-Vulnerability of the Financial System
 Large financial institutions (e.g. CountryWide)

Non-financial companies (e.g. Genetal Motors)

 The strongest companies in this downturn were those that integrated risk management as a more comprehensive part of corporate strategy.

Credit Risk

This lecture involves discussion of different types of loans, and the analysis and measurement of credit risk on individual loans.

This is important for purposes of:
   Pricing loans and bonds Setting limits on credit risk exposure Predicting Corporate Defaults

Types of Loans
1. Commercial and Industrial
      Syndicated Loan Secured Loan Unsecured loan Spot Loan Loan Commitment Commercial Paper

2. Real Estate Loans 3. Individual loans 4. Other loans

Credit Quality Problems Over Time

     

In the 1980s, problems with junk bonds, residential and farm mortgage loans. In the early 1990s, problems with commercial real estate loans as well as junk bonds. In the late 1990s, attention shifted to credit cards. Late 1990s, early 2000s: telecommunication, high technology companies etc. 2007-2009: Mortgage Crisis. Credit Quality Problems cause a FI to become insolvent, lead to drain in capital  reduce growth prospects and ability to compete with other FIs.

Calculating the Return on a Loan (ROA approach)

A numbers of factors impact the promised return an FI achieves on any given dollar loan:      Fees relating to the loan Interest rate on loan (base lending rate) Credit risk premium Collateral backing of the loan Other requirements such as compensating balances and reserve requirements


 Return = inflow/outflow

Outflow: 1 – b + bRR

1+k = 1+(of + (BR + m ))/(1 - [ b (1-RR)])
Origination Fee Base Lending Rate Credit Risk Premium

Compensating Balance Requirement Reserve Requirement

Example: Suppose the bank does the following

 

Set a loan rate at 14% (BR BR=12% and m=2%). Charges 0.125% as loan origination fee.

Imposes a 10% compensating balance requirements to be held as non-interest bearing demand deposits.
Sets aside reserves, at a rate of 10% of deposits, held at the Federal Reserve.


1+k = 1+(of + (BR + m ))/(1-[b(1-RR)])

=1+ [(0.00125+(0.12+0.02)]/[1-(0.10)(0.9)]=15.52%

Expected Return on a Loan

1+E(r)=p*(1+k) + (1-p)*0 (1-p)*0,
Where p=probability repayment


1-p=probability of default

• From formula (2), one can easily show that: E(r)=p*(1+k) – 1
• To the extent that p is less than 1, default risk is present.


Setting the Risk Premium

The FI manager must (1) set the risk premium (m) sufficiently high to compensate for the borrowers risk (2) recognize that setting a high risk premium as well as high fees and bases rates may actually reduce the probability of repayment

k and p not independent (e.g. can be negatively related)
The relationship between E(r) and k is not necessarily linear

Relationship between E(r) and k

Measurement of Credit Risk

A FI manager needs to measure the probability of borrower default.

Ability depends on the amount of information the FI…