Assume a 7-year, $5,000 par value bond paying a 12% coupon annually and a YTM of 10%. The prime rate is 4%. There will be a charge of $20 in fees and will have a 14% compensating balance imposed. The reserve requirement is 11%. The Treasury Note is yielding 1.25%. If the loan defaults, the bank will recover 65% of its money. Assume there is a concern of an increase in yields of 4%. The ROE (cost of funds) is 6.5%.

This loan is combined in a portfolio with a second loan that contains a face value of $3,000. This second loan has a Moody's KMV Return of 3.5% and Moody's KMV Risk of 12%. The correlation of the two loans is -0.65 and the bank is willing to take a maximum of a 20% loss. The national average allocation for the first loan is 45% and the national average allocation for the second loan is 55%.

What is the Risk Adjusted Return on Capital (RAROC)? Should the loan be approved according to this model?

What is the Moody's KMV Model Return? What is the Moody's KMV Model Risk?