1. A bank is planning to make a loan of $5,000,000 with duration of 7.5 years to \"Jumbo Manufacturing\

1. A bank is planning to make a loan of $5,000,000 with duration of 7.5 years to "Jumbo Manufacturing", a young and aggressive firm. The loan rate is 12% and the servicing fee is 50 basis points. The bank estimates that with a probability of 95%, the risk premium on the loan will not increase by more than 4.2%. The average cost of funds for the bank is 10 percent. The bank manager wants to use the RAROC approach to make a decision on approval/rejection of the loan: a. b. c. d. e. f. What is RAROC? Explain the concept theoretically. How does this model use the concept of duration to measure the credit risk of a loan? How is the expected change in the credit premium of the borrower measured? What is OLN in the RAROC equation? How is that measured? Apply RAROC to the data on the above loan. Calculate each component of RAROC. Should the bank approve the loan? Explain and show your work. If you believe the loan should be approved, how much lower can the loan rate go for the loan to be still approved? If you believe the loan should not be approved, how much should the loan rate be raised for the loan to be approved?