10

[CLO3] [20 marks]

A bank is planning to make a loan of $10 million to a firm in the textile industry. The duration of the loan to be approved is four years. The 99th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent.

In addition, the bank expects to charge a fee income on this loan of 0.5 percent and a spread over the cost of funds of 1 percent. Finally, the cost of funds (the RAROC benchmark) for the bank is 10 percent.

1- Compute the loan risk if the current average level of interest rates for this category of bonds is 10 percent? [5 marks]

2- Using the RAROC model, determine whether the bank should make the loan? Justify your answer [10 marks]

3- What should be the duration in order for this loan to be approved? [5 marks]