CREDIT RISK MANAGEMENT 1

Question 2 A consumer credit department of a commercial bank has developed a linear multi- regression model based on the past performance of its consumer loans. The department's officers use the model to assess the credit risk of consumer loan applications. The model takes the following form: Past loan performance = 0.6 + 1.5 (own home) + 0.6 (age > 55) + 0.2 (32 to 54) -0.4 (21 to 31) + 0.7 (monthly salaried) + 0.2 (retired) 0.6 (paid weekly) +0.3 (car loan) - 0.2 (home improvement loan) 0.4 (general loan) The variables are all of the binary type with a value of either 1 for the variable or zero. This means, for example, that if an applicant owns their own home they score 1 on the variable, otherwise it is zero. Past loan performance is 1 for good loans and 0 for loans where there was a problem with repayment. Required: (a) Using the above credit scoring model and assuming the cut-off is the mid-point on the rating scale, what will be the minimum acceptable score? (10 marks) Sandra, a professional (45 years old) who is paid on a monthly basis, has submitted an application for a loan to renovate her house. The applicant has owned her house for 12 years. Using the above credit scoring model, what will be the score of her application? Determine whether it would be accepted or rejected. (7 marks) A company has the following capital structure and volatility: Current value of the firm 1,600 Maturity value of the debt 920 Volatility 0.30 Risk-free interest rate 6.18366% Maturity of the debt 2 Find the value of the default put option on the debt using the Black-Scholes- Merton option pricing model and default spread. (15 marks) (d) How does the company's debt ratio, volatility of the underlying firm value and time to maturity affect the default spread? (8 marks) Question 2 A consumer credit department of a commercial bank has developed a linear multi- regression model based on the past performance of its consumer loans. The department's officers use the model to assess the credit risk of consumer loan applications. The model takes the following form: Past loan performance = 0.6 + 1.5 (own home) + 0.6 (age > 55) + 0.2 (32 to 54) -0.4 (21 to 31) + 0.7 (monthly salaried) + 0.2 (retired) 0.6 (paid weekly) +0.3 (car loan) - 0.2 (home improvement loan) 0.4 (general loan) The variables are all of the binary type with a value of either 1 for the variable or zero. This means, for example, that if an applicant owns their own home they score 1 on the variable, otherwise it is zero. Past loan performance is 1 for good loans and 0 for loans where there was a problem with repayment. Required: (a) Using the above credit scoring model and assuming the cut-off is the mid-point on the rating scale, what will be the minimum acceptable score? (10 marks) Sandra, a professional (45 years old) who is paid on a monthly basis, has submitted an application for a loan to renovate her house. The applicant has owned her house for 12 years. Using the above credit scoring model, what will be the score of her application? Determine whether it would be accepted or rejected. (7 marks) A company has the following capital structure and volatility: Current value of the firm 1,600 Maturity value of the debt 920 Volatility 0.30 Risk-free interest rate 6.18366% Maturity of the debt 2 Find the value of the default put option on the debt using the Black-Scholes- Merton option pricing model and default spread. (15 marks) (d) How does the company's debt ratio, volatility of the underlying firm value and time to maturity affect the default spread? (8 marks)