Exercise 3 A bank has just taken over another bank, and in relation to the transaction is discovered that a portfolio of loans given to a number of clients spread over the country exists. All loans are issued towards clients with a Aaa rating according to their internal rating model. A model that is comparable in performance with standard models like Moodys and Standard & Poors: The Bank wants you to assess how much capital that should be reserved for this particular business that has been merged in. The bank is Advanced IRB. Currently the existing model for estimating PD is not build for estimating these kind of loans, and thus the bank is uncertain of the level of default probability. You want to let a market traded instrument decide on the approximate level of the PD for the portfolio. You have found a Aaa rated corporate bond that is quite liquid in the market with the following characteristics. A 5 year 3,5% coupon bond with yearly coupons. All redeemed at maturity. A recovery rate of 40% can be used for calculations. The yield of the bond is 4%, and the risk free yield in the market is 2%. You can assume defaults happen just before the coupon date Question 3.1 After you analysis of the corporate bond - what level of PD do you estimate could be used for evaluating the loan portfolio. What is the time horizon for your estimate Exercise 3 A bank has just taken over another bank, and in relation to the transaction is discovered that a portfolio of loans given to a number of clients spread over the country exists. All loans are issued towards clients with a Aaa rating according to their internal rating model. A model that is comparable in performance with standard models like Moodys and Standard & Poors: The Bank wants you to assess how much capital that should be reserved for this particular business that has been merged in. The bank is Advanced IRB. Currently the existing model for estimating PD is not build for estimating these kind of loans, and thus the bank is uncertain of the level of default probability. You want to let a market traded instrument decide on the approximate level of the PD for the portfolio. You have found a Aaa rated corporate bond that is quite liquid in the market with the following characteristics. A 5 year 3,5% coupon bond with yearly coupons. All redeemed at maturity. A recovery rate of 40% can be used for calculations. The yield of the bond is 4%, and the risk free yield in the market is 2%. You can assume defaults happen just before the coupon date Question 3.1 After you analysis of the corporate bond - what level of PD do you estimate could be used for evaluating the loan portfolio. What is the time horizon for your estimate