FINS3630 Lecture Notes - Lecture 4: Prime Rate, Credit Risk, Origination Fee
Lecture 4: Credit Risk I: Individual loan risk
- FI transforms household savings into claims issued to other households, corp, gov → credit
approval process
- Measuring and monitoring credit risk: accept/decline loan; price loan or value bond; set
appropriate limits on credit extended to single borrower; overall CR
- Commercial and industrial: ST loans (working capital) + LT loans (LT capital) + syndicated
loans (rates, fees, covenants)
o Secured vs unsecured
o Fixed/floating
o Spot loan vs loan commitment: spot take entire loan amount immediately vs. Loan
commitment (line of credit- over commitment period)
- Commercial papers
o Unsecured, ST, form of disintermediation traded by money market mutual funds
o Used by large corp w good credit rating- direct access to funds in capital markets
- Real estate loans
o Size of loan, ratio of loan to property value, maturity, mortgage rate (fixed vs.
floating- adjustable to underlying index), fees/charges
- Consumer loans
o Non-revolving: traditional (personal, car)
o Revolving: credit-line borrower can repay and draw many times over contract life
(credit card)
- Loan interest rate = Base lending rate (BR- libor, prime lending rate- periodically set by
banks charged to lowest risk) + credit risk premium (ø)
- Fees: origination fee (of), compensating balance requirements (b) (% of loan borrower
holds as deposit in checking acct- used to offset set up fee), reserve requirements for FI
(RR)- cash deposit/liquidity ratio
- Contractually promised gross return (k):
- E(return of a loan) (deviates from k quod default risk)
o E(1+r) = p*(1+k) + (1-p)*0 = p*(1+k)
o E(r) = p*(1+k) – 1 , (p,k are not indep)
- Retail credit decision
o Household borrowers smaller loans, cost of information collection per dollar or loan
is higher, retail loans accept/reject decisions, mortgage loan-to-value ratio
- Wholesale credit deicion
o Larger loan sizes, IR and credit quantity used to control for credit risk, risky
borrower receives if sufficiently high IR, E(r) does not increase in the promised k
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- Qualitative risk models
o Borrower specific factors: reputation, leverage (bankruptcy risk D/E)
o
▪ volatility of earnings, collateral (lender direct claim to collateral- less risky
ut those good redit ratigs should’t eed ollateral
o market specific factors: business cycle (customers/FI), IR level (high IR p to higher
credit risk)
o models: numerically det which factors are relevant, det relative importance of
factors, improve default risk pricing, better loan applicant screening, calculate
reserves needed for potential future losses
o linear probability model: assumes past exp influences fut exp
▪ where PD=1 for default, = 0 if repaid
▪
• note, E(Pr) can lie outside 0:1 interval
o logit model:
o linear discriminant models: variable is a score, not Pr
o altman linear discriminant model:
▪ X1: Working capital/ total assets (liquidity)
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Lecture 4: credit risk i: individual loan risk. Fi transforms household savings into claims issued to other households, corp, gov credit approval process. Measuring and monitoring credit risk: accept/decline loan; price loan or value bond; set appropriate limits on credit extended to single borrower; overall cr. Commercial papers: unsecured, st, form of disintermediation traded by money market mutual funds, used by large corp w good credit rating- direct access to funds in capital markets. Real estate loans: size of loan, ratio of loan to property value, maturity, mortgage rate (fixed vs. floating- adjustable to underlying index), fees/charges. Consumer loans: non-revolving: traditional (personal, car, revolving: credit-line borrower can repay and draw many times over contract life (credit card) Loan interest rate = base lending rate (br- libor, prime lending rate- periodically set by banks charged to lowest risk) + credit risk premium ( )
