Question

b. Une-yuai U 7. A FI wants to evaluate the credit risk of a $8 million loan with a duration of 5.6 years to a AAA borrower. The current average level of rates (R) on AAA bonds is 9 percent. The largest increase in credit risk premiums on AAA loans, over the last year was equal to 1.4 percent. The projected (one-year) spread on the loan is 0.35 percent and the FI charges 0.28 percent of the face value of the loan in fees, Calculate the capital at risk and the RAROC on this loan

Answer 1

Adjusted income = Spread + Fees = 0.35% + 0.28% = 0.63% x Face value = 0.63% x $ 8 million = $ 0.0504 million

Capital at risk = Duration x Loan x ΔR / (1 + R) = 5.6 x 8 million x 1.4% / (1 + 9%) = $ 0.5754 million

Hence, RAROC = Adjusted income / Capital at risk = 0.0504 / 0.5754 = 8.76%