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Using Regression Analysis on Historical Loan Losses - Accounting and Finance Assignment Help

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NOTE: In opening this exam paper and submitting these questions you are declaring that you have completed the exam yourself, under examination conditions. Note: Submissions that are overdue will not be marked.
Open and read the article located on LMS.
SECTIONS I & II: Please answer questions 1-7 on the test paper attached (in the spaces provided). Show all calculations. Answers should be concise.
SECTION III: After reading the article answer Question 8. Please answer this question on the exam paper attached in the space provided. The answer should be concise.
The total mark is 100
QUESTION 1[5 Marks]
Using regression analysis on historical loan losses, a bank has estimated the following:
XPMC=0.002+1.5XPM and XPMR=0.002+2.75XPMwhere XPMC equals the profit margin in the commercial sector and XPMR equals the profit margin in the retail sector and XPM equals profit margin for its total loan portfolio. The senior bank manager questions this regression result. However, based on the regression analysis alone what sector should the bank limit its loans.
Reconcile the existence of both retail and commercial loans.
QUESTION 2 [5 Marks]
Discuss how a contract design, which uses the multi-period borrower-lender relationship, avoids the under-investment problem. Be specific.
QUESTION 3a [ 3 Marks]
Suppose the estimated logit model is

What is the probability of default for the respective borrowers?
Borrower Probability of Default
Borrower A 0.1379 2.6123 Borrower B 0.3703 1.9941 QUESTION 3b [ 3 Marks]
What other information would be needed for the loan approval decision using this model?

QUESTION 3c [ 4 Marks]
What other information would be needed for the loan approval decision?

Answer these questions in the space provided
show all workings
QUESTION 4 a [ 8 Marks]
The Bank of Tinytown has two loans that have the following characteristics. If the covariance between A and B is 0.065, what are the expected return and standard deviation of this portfolio? Given the covariance, can the calculation be simplified? What will the risk of the portfolio be, given the simplification?
Loan Size ($ million) Return (%) Variance (%)
Loan A $ 1,600.0 7.50 5.0
Loan B $ 800.0 12.0 9.5
QUESTION 4b [ 2 Marks]
Briefly describe any way(s) that the risk of this portfolio may be reduced? Be specific.
Consider a borrow a that can choose between two projects, S and R, each of which will pay off a random amount one period hence. Project S will yield $280 with probability all 0.8 and zero with probability 0.2 one period hence. Project R will yield $340 with probability 0.5 and $60 with probability 0.5 one period hence. As a banker you cannot control the borrowers project choice. Assume the bank’s cost of funds is equal to zero and the bank officer assumes universal risk neutrality. Moreover, you can charge a borrower 400 basis points above your break-even interest rate before the borrower switches to another bank. Compute the expected payoffs of the borrower and the bank under the following two scenarios:
the bank and the borrower can contract with each other however over only one period and the borrower will request a single line of $150.
the borrower will need a sequence of two $150 loans, with the ability to choose between S and R in each period.
QUESTION 5a [ 6 Marks]
Scenario (i)

QUESTION 5a [ 6 Marks] (continued)

QUESTION 5b [ 12 Marks]
Scenario (ii)

QUESTION 5b [ 12 Marks] (continued)

QUESTION 5c [ 2 Marks]
What should be the choice of the contracting horizon? Will the bank obtain its return?

QUESTION 6a [ 10 Marks]
Consider a firm managed by an entrepreneur. The firm has two kinds of debt outstanding: senior debt under which it owes $1,250 to bondholders, and a subordinated bank loan that requires a repayment of $2,550. The firm’s assets have a current liquidation value of $2,800 but if the firm continues to operate, it will be worth $3,750 with probability 0.8 and $100 with probability 0.2 one period hence. To manage the firm for an additional period, the entrepreneur incurs a personal cost of $400. The entrepreneur has declared that she wishes to file for bankruptcy and has contacted both the bank and the bondholder’s trustee. The bondholders wish to liquidate the firm immediately. Assume risk aversion by the participants and explain the effect on each participant. How would you recommend solving this problem? What should the bank do? Justify your answer.

QUESTION 6a [ 10 Marks] (continued)
QUESTION 6b [ 5 Marks]
Suppose the estimated Altman discriminant analysis model is

Borrower A 0.20 0.00 -0.20 0.10 2.00
Borrower B 0.15 0.10 0.20 0.40 1.50
What is the Z score for borrower A and borrower B respectively?
Given no other information which borrower is more creditworthy? Why? Be specific.

QUESTION 6b [ 5 Marks] (continued)
QUESTION 6c [ 5 Marks]
Consider the cost of funds - the risk adjusted return on capital (RAROC benchmark) for a bank and identify some of the limitations of using this approach. Use the RAROC formula to inform your limitations.
QUESTION 7a [ 7 Marks]
Consider the following loan categories:
Loan Type Singapore Banks
Total ($b) Bank A ($b) Bank B ($b) Bank C ($b) Bank D ($b) *
Real Estate 4,800 21 20 10 Commercial 10,200 171 24 12 Industrial 3,200 42 20 10 Consumer 2,800 18 16 8 Travel and Hospitality 4,000 20 30 45 Other 15,000 48 20 10 * Bank D is only investing in short-term government securities.
Which bank has the most diversified portfolio? Show all calculations. [Hint: Use the formula presented in the course.]
QUESTION 7b [ 8 Marks]
Explain why the approach that you employed in Question 7a has benefits and limitations. Ensure that the benefits and limitations are justified and clearly explained. What impact would COVID -19 have on your answer.

QUESTION 8 [ 15 Marks]
Ensure you have read:
Laurent, Plantefeve, Tjada and Weyenbergh, (2020). Banking models after COVID-19: Taking model-risk management to the next level, McKinsey & Company, 1-5.
available from the LMS site before attempting this question.

Analyse the article, Laurent et al. (2020) “Banking models after COVID-19: Taking model-risk management to the next level” and compare and contrast the article with the specific material presented in the BUS308 Credit and Lending course. Please write within the space provided below.
NOTE: This has a strict word limit of 750 words so plan your response carefully.

QUESTION 8 [ 15 Marks] (continued)

QUESTION 8 [ 15 Marks] (continued)

You may use the formulae provided below to assist you in answering the questions. You should show all workings to gain credit for partly correct answers in your examination.


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