Chapter 11

Question 1

How can a banks reduce credit risk with their loans?

Answer 1

By having diversified loans meaning you lend to people in different industries so not on industry is too concentrated (ex: lend to restaurant and lend to pawn shop. When one goes down, the other may go up)

Question 2

Can banks have negatively correlated loans?

Answer 2

Yes

Question 3

What is migration analysis

Answer 3

It is a system that tracks credit rating of firms in a particular industry

Question 4

Draw an example of a loan migration matrix and explain it

Question 5

Can it happen where a loan starts as an AAA and go to other ratings?

Answer 5

Yes loans can go up and down in terms of rating

Question 6

What is special about the D category in the loan matrix?

Answer 6

No matter what rating the loan started at, if the rating goes to D that means it is a default loan. You would add up the D rating in loan matrix and that would be the percentage of default loan

Question 7

What is concentration limits in terms of loans? Give an example

Answer 7

It is where the bank will limit the amount of money they loan out in certain industries.
(ex: bank has 20% of their loans dedicated to mortgages)

Question 8

What is large exposure limits

Answer 8

It is the max amount of credit a bank can have to a single borrower which is 25% in Canada. The 25% is amount of capital (equity) of the bank NOT percentage of their assets

Question 9

What are the 2 ways the concentration limits are set

Answer 9

1) Based on the chances of the loan defaulting
2) Based on how much they can lend in regards to their capital

Question 10

What is minimum risk portfolio

Answer 10

One that applies modern portfolio theory which is a combination of assets that reduce portfolio risk to the lowest feasible level

Question 11

How do you calculate interest spread

Answer 11

Interest customer is paying - cost of interest for the bank

Question 12

What does potential loss of capital

Answer 12

Means if the loan defaults, the bank is exposing themselves to that amount of capital
(ex: potential loss of capital is 25%. That means if the loan defaults, the bank is exposing themselves to 25% of the amount the lent out on that specific loan)

Question 13

What is the formula for calculating the expected return

Answer 13

(Interest spread + annual fees) - (prob of default x potential loss)

Question 14

What is the formula of the risk

Answer 14

(square root of (prob of default x prob of not defaulting)) x potential loss

Question 15

Give 5 ways to say which loan is riskier than the other

Answer 15

1) higher spread in interest is riskier
2) higher probability of default is riskier
3) higher potential loss of capital is riskier
4) higher fees on the loan is riskier
5) higher standard deviation is riskier

Question 16

With a two security portfolio, how do you calculate expected return of the portfolio

Answer 16

Expected return = (weight A x return A) + (weight B x return B)

Question 17

When combining two securities, how do you know if modern portfolio theory is being applied?

Answer 17

You look at risk of both securities alone but when they are put together, the overall risk should go down

Question 18

What are SIC codes

Answer 18

They are standard industry codes based on the industry the business is in. This makes it easy for banks to classify their loans and determine the weight of their portfolio based on how much loan is in each SIC code to allow the bank not to over expose themseleves

Question 19

What are the two types of regulatory aspects to remember?

Answer 19

1) The bank cannot loan more than 25% of their capital to one entity
2) The bank cannot loan out any more than than 5% of their assets to any sort of policy for property, casualty or life insurance