Please show work and how you arrived at your conclusion. The assignment may be s
ID: 2717389 • Letter: P
Question
Please show work and how you arrived at your conclusion.
The assignment may be submitted as an Excel spreadsheet or an electronic (Word or PDF) document.
2. A financial institution is planning to give a loan of $5 million to a firm. It expects to charge an up-front fee of 0.20%
and a service fee of 5 basis points. The loan has a maturity of 8 years. The cost of funds for the financial institution is 10%.
The FI has estimated a risk premium of 0.15%. The current market interest rates for this type of loan is 10.1%.
The 99th (extreme case) loss rate for borrowers of this type has historically run at 4%.
The dollar proportion of loans of this type that cannot be recaptured on default has historically been 85%.
Using the RAROC model, would you recommend that the FI make this loan? Why?
Explanation / Answer
RAROC = Fees and interest earned on loan/ Loan or capital risk Loan risk,
or LN = -DLN*LN*(R/(1 + R) = = -$5m * (.15/1.101) = - $681,198.91
Expected interest = 0.101 x $5,000,000 = $505,000
Servicing fees = 0.0050 x $5,000,000 = $25,000
Less cost of funds = 0.10 x $5,000,000 = -$500,000
Net interest and fee income = $30,000
RAROC = $30,000/681,198.91 = 4.4 percent.
Since RAROC is lower than the cost of funds to the bank, the bank should not make the loan.