Reference no: EM132379925

Bank XYZ is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the maximum change in the risk premium on the stee manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent.

a. Using the RAROC model, determine whether the bank should make the loan?

b. What should be the duration in order for this loan to be approved?

c. Assuming that duration cannot be changed, how much additional interest and fee income will be necessary to make the loan acceptable?

d. Given the proposed income stream and the negotiated duration, what adjustment in the maximum change in the risk premium would be necessary to make the loan acceptable? Explain the consequence of adjustment on the maximum change in the risk premium on the economic capital required to buffer the loan!