BUS307: Suppose a Borrower knows at Time That it Will Have Available at Time t = 1 an Opportunity to Invest $340 in a Risky Project: Commercial Banking Assignment, MU, Singapore

QUESTION 1a

Suppose a borrower knows at time t = 0 that it will have available at time t = 1 an opportunity to invest $340 in a risky project that will pay off at time t = 2. The borrower knows that it will be able to invest in one of two mutually exclusive projects, S or R, each requiring a $340 investment. If the borrower invests in S at time t = 1, the project will yield a gross payoff of $620 with a probability of 0.8 and $180 with a probability of 0.2 at time t = 2. If the borrower invests in R at time t = 1, the project will yield a gross payoff of $675 with a probability of 0.6 and $100 with a probability of 0.4 at time t = 2. The borrower’s project choice is not observable to the bank.

The riskless, single-period interest rate at time t = 0 is 10%. It is not known at time t = 0 what the riskless, single period interest rate at time t = 1 will be, but it is common knowledge that this rate will be 8% (with probability 0.65) or 15% (with probability 0.35). Assume universal risk neutrality and that the borrower has no assets other than the project on which you (as the lender) can have a claim.

Suppose you are this borrower’s bank and both you and the borrower recognize that this borrower has two choices: (1) it can do nothing at time t = 0 and simply borrow at the spot market at an interest rate prevailing for it at the time t = 1, or (2) it can negotiate at time t = 0 with you (or some other bank) for a loan commitment that will permit it to borrow at predetermined terms at time t = 1.

What advice should you give this borrower? Assume a competitive loan market in which each bank is constrained to earn zero expected profit. Determine the NPV of the alternative(s) that you recommend.

QUESTION 1b

Suppose bank A has two loans, each of which is due to be repaid one period hence and whose cash flows are perfectly positively correlated and identically distributed random variables. Each loan will repay $365 to the bank with a probability of 0.7 and $180 with a probability of 0.3. However, while bank A knows this, prospective investors cannot distinguish the bank’s portfolio from that of bank B that the same number of loans, but each of its loans will repay $365 with a probability of 0.45 and $180 with a probability of 0.55.

The prior belief of investors is that there is a 0.70 probability that bank A has the higher-valued portfolio and a 0.3 probability that bank B has the lower-valued portfolio. Suppose that bank A wishes to securitize these loans, and it knows that if it does so without credit enhancement, the cost of communicating the true value of loans to investors is 5.0 percent of its true value.

Explore bank A’s securitization alternatives. Assuming that a credit enhancer is available and that the credit enhancer could (at negligible cost) determine the true value of the loan portfolio, what sort of credit enhancement should bank A purchase? Assume that everybody is risk-neutral and that the discount rate is zero.

QUESTION 2

The market value of the assets of a corporation is currently $145 million but the owners wish to only use as collateral a value that will result in an interest rate of about 10%. The firm has on issue a debt outstanding that has a par value of $15 million and a due date of exactly five years. No intermediate interest payments are required. The risk-free (continuous) rate is 3.25% and the standard deviation of returns of the firm’s assets is 60%.

What is the value of the assets required by the debt holders to permit a fair interest rate of approximately10% (your answer should ensure that the fair interest rate is in the range of >9% and <11%)?

State any simplifying assumptions made in your calculations.

QUESTION 3

Use this balance sheet information to answer the following questions:

The variable loans are repriced every 180 days.

The bank has granted a special loan that has 5 years to maturity and has repayments of $218.20 million at the end of year 1, $235.60 million payment at the end of year 4 and $290.55 million payment at the end of year 5. The loan is trading at par and the yield to maturity is 4 percent per annum.

The yield curve is flat, and the interest rate is 4%. The financial institution decides to use a 3-year swap. The swap is composed of a three-year bond with a fixed coupon rate of 4 percent paid annually and a floating-rate bond with a duration of approximately zero.

Using this swap, determine the notional principal of the swap and advise the financial institution on whether it should be a fixed or floating payer. Present an explanation including pertinent assumptions of how the swap you have recommended works.

QUESTION 4

The ALCO committee believes that  = 0.01 would be a reasonable estimate of relevant interest rate movements.

If the 90-day bank bill futures are quoted at 96.0 and there is no basis risk, calculate the number of future contracts to macro-hedge the bank’s balance sheet.

Show all calculations and specifically state whether a short or long position is recommended

SECTION B 

ANSWER ALL QUESTIONS IN THE SPACES PROVIDED ON THE PAPER.

QUESTION 5

To fairly price the default risk of a loan to a particular firm, a lender should always increase the loan interest the greater is the firm’s level of dividend payout. Discuss.

QUESTION 6

“Credit enhancements” (such as banks retaining a subordinate claim in a pool of loans or obtaining a third-party guarantee in the form of a letter of credit) are needed when loans are securitized because investors who buy loans tend to be risk-averse. Discuss.

QUESTION 7

Suppose that a bank with a positive net worth perfectly matches the duration of its assets and liabilities. What will happen to the value of this bank’s shares if interest rates rose unexpectedly? Discuss.

SECTION C

QUESTION 8

Answer this question after CAREFULLY reading:

Greenbaum, Thakor, and Boot (2016) and Couppey-Soubeyran, Perego, and Tripier (2020)

Review Greenbaum, Thakor, and Boot (2016) Chapter 14 – “The 2007 – 2009 Financial Crisis and Other Financial Crisis” and compare the insights of the chapter with the issues facing banks identified by Couppey-Soubeyran, Perego, and Tripier (2020).

Your answer must show how you can apply what was covered in BUS307 in a real-world situation. Insightful observations and discussions will attract a superior grade. Conversely inserting paragraphs/sections of Chapter 14 from Greenbaum et a. (2016) or Couppey-Soubeyran (2020) will not be viewed favorably. Also, recall that plagiarism can result in a zero grade.

Normal Distribution Table