Q1. RAROC (risk-adjusted return on capital) Models (a) What is the essential idea underlying RAROC models? How does the RAROC model relate to the concept of duration? (b) The duration of a soon to be approved loan of $10 million 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%. The current average level of interest rates for this category of bonds is 12%. If the fee income on this loan is 0.4% and the spread over the cost of funds to the bank is 1%, calculate the estimated RAROC of this loan.

Q2. (a) Using a modified discriminant function similar to Altman's, Sunshine Bank estimates the following coefficients for its portfolio of loans: Z = 1.4X1 + 1.09X2 + 1.5X3, where X1 = debt to asset ratio; X2 = net income and X3 = dividend payout ratio. What is the Z-score if the debt to asset ratio is 40%, net income is 12%, and the dividend payout ratio is 60%? (b) Moon Bank has made a loan to Lucky Corporation. The loan terms include a default risk-free borrowing rate of 8%, a risk premium of 3%, an origination fee of 0.1875%, and a 9% compensating balance requirement. Required reserves at the Fed are 6%. What is the expected or promised gross return on the loan?