1. The RAROC (risk-adjusted return on capital) Model:

Merry bank is planning to make a loan of $5,000,000 to Star Company, which operates in the hospitality industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the maximum change in the risk premium on the hospitality sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent.

(b) What should be the duration in order for this loan to be approved? (4 marks)

(c) Assuming that duration cannot be changed, how much additional interest and fee income will be necessary to make the loan acceptable? (3 marks)