Review Questions 41.docx

Review Questions 41.docx

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FIN2108Module4ReviewQuestions4.1

Reviewquestions4.1

4.1.1PleaseattemptQuestions1-10onpages132-133ofSathyeetal..

4.1.2Iftherisk-freerateis8%andtheloanrateis13%,whatistheprobabilitythattheloanwillbefullyrepaid?

4.1.3Iftherisk-freerateis8%andtheloanrateis16%,whatistheprobabilityofdefault?

4.1.4Considerathreeyearloanwheretheprobabilityofdefaultinanygivenyearis5%.Whatisthecumulativeprobabilityofdefaultoverthe3yearloanperiod?

4.1.5Acertaincategoryofloanspayarateof8%,whiletheriskfreerateis3.5%.Whatisthecreditrisk（pr）iftherecoveryrateis70%?

4.1.6Giventhefollowinginformation,calculatethecumulative,twoyearprobabilityofdefaultforcorporatebonds,assumingzerorecoveryintheeventofdefault:

One-yearrate（%）Two-yearrate（%）

GovernmentBonds45

CorporateBonds68

4.1.7Abankuseslinearprobabilitymodelingtoanalyzepastdefaultpatternsinitssmallbusinessloanportfolio.

Itdeterminesthefollowingrelationship:

IfSmallBusiness1hasthefollowingratios,whatistheexpectedprobabilitythataloantoSmallBusiness1willberepaid?

Ratios

values

ROE

0.2

ROA

0.18

NetProfitMargin

0.15

AssetUtilisation

1.2

currentratio

1.4

Chapter4

Creditriskanalysis–anintroduction

Solutionstodiscussionquestions

Q1.Definecreditrisk.

A.Creditriskistheriskthattheprincipalandinterestpayableonaloanwillnotbepaidinatimelymanner.Formostloans,documentationgenerallydefinesthisasonorbeforetheduedate.Youcouldalsoincludeanyincreaseincollectioncostsassociatedwithadeteriorationinaloanaspartofcreditrisk.

Q2.Whatareexpertsystems?

Outlinetheproblemswithrelyingonexpertsystems.

A.Expertsystemsareproceduresforanalysingloanproposalsthatarelargelybasedontheskillofthecreditanalyst.Theyarenormallyappliedusingacronymssuchasthe5C’sorPARSER（whichisanothermodelforanalysingrisk）.Acharacteristicofexpertsystemsisthatfinancialanalysistakesuponlyapartoftheoverallanalysis.Inotherwords,muchoftheanalysistendstobesubjectiveratherthanobjective.Ratioanalysistendstobetheprincipalobjectiveanalysisforthisprocedure.Itisthesubjectivitythatcausesthemostproblemsforexpertsystems.Boththeanalysisoftheframeworkandthedatacanbeambiguous.

Q3.Whatisthebasisofusingmarket-basedriskpremiums?

Whydocreditanalystsnotusethemmoreregularly?

Thebasisofmarket-basedpremiumsisthattheprobabilityofrepaymentordefaultriskofaloancanbedeterminedfromthetermstructureofcreditrisk.Thisisasimilarconcepttothetermstructureofinterestrates.

Simplyput,itistheriskpremiumthatisaddedtotheloanbasedontheprobabilityofrepayment,thatmakesalenderindifferentbetweentheloanandriskfreegovernmentdebt.Theproblemwiththeapproachisthatitassumesthatthepremiumbetweenriskfreeandriskydebtisallcreditrisk.

However,researchhasbeenshownthatthepremiumisnotallcreditrisksandrepresentsotherfactorsaswell.Thesefactorsinclude:

∙Theliquidityofthedebtissue.

∙Anycovenantsonthedebtissue.

∙Theseniorityofthedebtissue

∙Industryissues.

Notethatpremiumscanbeadjustedtoaccountforanyrecoveries（eg.saleofassets）inthecaseofdefault.DT

Q4.Howhasthedevelopmentofstatisticaltoolshelpedcreditanalysts?

Explainwhythesetoolscannotbethesolebasisfordecision-making.

A.Priortothedevelopmentofstatisticaltoolsforcreditanalysis,loansweremadeusingexpertsystemsthatusedtheexpertiseoftheanalystastheirbasis.Theywerepronetoerrorduetotherelianceonhumanjudgement.Theintroductionofstatisticaltoolshastakenmuchofthesubjectivityoutofcreditanalysis.Insteadofhumanjudgementbeingthesolebasisofassessment,statisticaltoolsensurethatmoreobjectivemeasuresarealsoused.Theseobjectivemeasurescanthenbemeasuredagainstabenchmark.However,thesetoolscannotbethesolebasisfordecision-makingforthefollowingreasons:

∙Theytendnottohavethevalueoftheloanaspartoftheassessment.

∙Theydonotmodelterms,conditionsandcovenants.

∙Theydonothaveseniorityaspartoftheirmodels.

∙Theyignoretherelationship,（whichcouldbeagoodthing）.

∙Nomatterhowcomprehensivethemodel,theymayomitatleastonevariablethatisimportantforcreditriskmanagementormeasurement.

Q5.Explainthebasisofdiscriminantanalysisforcreditanalysis

Discriminantanalysisseekstodistinguishbetweentwopopulationsusingasetnumberofcharacteristics.Inshortitisastatisticalmethodanddoesnotnecessarilyutiliseanyfinancialtheory.However,itmayassistintheanalysisofcreditworthyandnon-creditworthycompanies.

…………………………………………………………………………………………………

Theremainingquestionsarebasedonthefollowingproposal.

Afinancialservicesproviderthatprovidescomputersoftwaresystemsapproachesyou.ThecompanystartedoffasasmallprivatecompanyandhasgrownstronglyoverthepastfifteenyearsandlistedontheAustralianStockExchange.Thecompanyhasbusinessesinmanyoff-shorelocations,allofwhicharewell-developedcapitalmarkets.Insomepartsoftheworld,thecompanyhasnear-monopolymarkets.

Aspartofitsstrategy,thecompanyusesacquisitionsratherthangrowthtocontinuetoexpandthebusiness.Whilethebusinessissoftwarebased,itreliesoncontinuedactivityinthefinancialmarkets.

Thecompanyhashadthesamemanagementoverthepastfifteenyearsandtheseniormanagementteamareshareholdersinthecompany.

ThecompanyisratedBBBanditsbondsaretradingat3.3percentabovethecomparablegovernmentbondrate,withthesharepricebeing$5.60.Yourbank’sexperienceisthattherecoveryrateintheeventofdefaultis50percent.Thecondensedfinancialaccountsareasfollows:

$M

Totalcurrentassets

66.3

Totalnoncurrentassets

659.9

Totalassets

904

Totalcurrentliabilities

197.3

Totalnoncurrentliabilities

243.7

Totalliabilities

473.0

Shareholder’sfunds

546.7

Retainedearnings

84.0

Sharesonissue

547,612,000

Earningsbeforeinterestandtaxis$151,608,000onsalesof$742,613,000.Thefirmisrequestingaloanof$150milliontoassistfurtheracquisitions.

Q6.Carryoutacreditanalysisonanexpertbasis.

A.Tocarryoutthisanalysisonanexpertbasiswewillusethe5C’sapproach.

Character

Thereisoneimportantissuewiththiscompanyintermsofitscharacterandthatisit’slistingontheAustralianStockExchange.Ifthecompanyhasbeendiligentinsubmittingitsreports,thereshouldbenodoubtsonitscharacter.However,itisimportanttonotethattheuseofthefundsisnotparticularlywelldefined.Whilethecompanyhasusedacquisitionstogrow,thereisnodataontheuseofthesefunds.Thisshouldbequestioned.

Capacity

Thereisnoindicationthatthecompanyisbankruptsotheredoesnotappeartobeanyreasonthatthecompanycannotborrow.Anauthenticatedboardminuteauthorisingtheborrowingandthedelegatedauthoritiesneedtobesought.

Cash

Thenormalwaytoviewthiscomponentisbydoingsomerudimentaryfinancialstatementanalysis.However,thereisapointtobemadefirst.Theaccountsaspresenteddonotbalance.Thisnotamistakeandisneededtohighlightthatcaremustbetakentoexaminetheaccountsindependently.Incorrectorsloppyaccountscouldrevealthewaythecompanyoperates.Havingsaidthis,someratiosthatwerelookedatinthetextareasfollows.

Aliquidityratiowhichisasfollows;

Thisiswellbelowthenormalbenchmark.Itcouldindicateadifficultyinpayingaccountsastheycomedue.

Anefficiencyratio.Itwillbenotedthatthereisnoinventorynumberintheaccountsasprovided.Ifwemakethecrudeassumptionthatallthecurrentassetsareinventorywewouldget.

Whilethisresultappearsgoodbeingabovetheroughbenchmarkof4times,itwouldneedtobebalancedoffagainstindustryaverage.

Aprofitabilityratioasfollows:

Thisappearstobeverysatisfactory.

Finally,wewouldlookatsolvency.

（Note:

theequitynumberisthenumberofsharestimetheshareprice.Therewillbesomedisputeonwhetherthebookvalueormarketvalueistaken.Forthepurposeofthisexercise,itisassumedthatweusethemarketvalue）.

Thiscalculationisassumingthatthenumberofsharesisactually547612000,ratherthan547612asindicatedintheoriginalquestion.Ieditedthetableabove（DT）

However,ifweusebookvaluewewillhave:

or75%.Amuchlargerratio.

Collateral

Nocollateralhasbeenoffered.Iftheloanisconsideredtoberisky,thencollateralshouldbesought.However,themainassetofthecompanyissoftwareandthiscouldbedifficulttovalue.

Conditions

Thisisthemostdifficulttoassess.Thecompany’searningsarehighlydependantonthestateofthefinancialmarkets.Ifthereisabearmarkettheearningsavailabletomakerepaymentswouldbereduced.Therefore,thereissomesusceptibilitytothegeneraleconomy.

Conclusions

Thiscasehighlightstherisksinexpertsystems.Tosomeextentitshowshowinexactandinconclusiveitis.Onthebalanceofprobability,alenderwouldprobablyapprovetheloan.However,thecashcomponentdoeshighlightthedangeroflendingtothisfirm.

Q7.Carryoutacreditanalysisonamarket-premiumbasis.

A.Theprobabilityofrepaymentcanbeinferredfromthefollowingrelationship:

p（1+r）=（1+i）

Note:

ariskfreeratehasnotbeensupplied.Atthetimeofwriting,theratewas5%sotheanswerwillbe:

p（1+