Part B (11 marks) page 6 The risk department of your bank is analysing the credit risk of the Building Company Ltd (BC) loan over the next two years. The following table shows the expected return on the BC loan and a govemment loan with similar characteristics. One year rate (%) Two Year rate (%) 3.50 4.25 Gov't loan Building Company Loan Spread (risk premium) 7.00 8.25 3.50 4.00 B The bank is unwilling to invest in any debt instrument with a probability of default greater than 2 25%. Should this loan be approved and held over two years (assume no cash payments in the event of default)? (3 marks) The risk manager thinks that the recovery rate on the bond is expected to be 70% in the event of default and is interested in holding the bond for one year. Should the bond be purchased? Justify your decision. (6 marks) Why is the risk premium different from the credit risk? (2 mark) C Part B (11 marks) page 6 The risk department of your bank is analysing the credit risk of the Building Company Ltd (BC) loan over the next two years. The following table shows the expected return on the BC loan and a govemment loan with similar characteristics. One year rate (%) Two Year rate (%) 3.50 4.25 Gov't loan Building Company Loan Spread (risk premium) 7.00 8.25 3.50 4.00 B The bank is unwilling to invest in any debt instrument with a probability of default greater than 2 25%. Should this loan be approved and held over two years (assume no cash payments in the event of default)? (3 marks) The risk manager thinks that the recovery rate on the bond is expected to be 70% in the event of default and is interested in holding the bond for one year. Should the bond be purchased? Justify your decision. (6 marks) Why is the risk premium different from the credit risk? (2 mark) C