Assume that an officer of ZED Bank wants to execute a transaction with the following characteristics using the risk-adjusted return on capital (RAROC) model:▪ Probability of default (PD) = 45 basis points▪ Loss given default (LGD) = 50%▪ Exposure at default (EAD) = US$ 2.0 million▪ The risk-free rate of return is 6%This is a loan to an agricultural company and the bank’s economic capital (EC) model delivers the following charge for the firm: EC of exposure = 5% of EAD, which is US$ 100,000. Assume that the bank has set a RAROC hurdle rate of 15% and this transaction has a net profit of US$ 12,000 before other adjustments.REQUIRED:1. Compute the bank’s risk-adjusted rate of return on the loan to an agricultural company? 2. Now assume that the bank could also have made a loan for the same amount and net profit of US$ 12,000 before other adjustments to a chemical manufacturing firm, and that the EC = 2.5% in this case. 3. Which loan between the two should the bank grant and why?
Assume that an officer of ZED Bank wants to execute a transaction with the following
characteristics using the risk-adjusted return on capital (RAROC) model:
▪ Probability of default (PD) = 45 basis points
▪ Loss given default (LGD) = 50%
▪ Exposure at default (EAD) = US$ 2.0 million
▪ The risk-free
This is a loan to an agricultural company and the bank’s economic capital (EC) model
delivers the following charge for the firm: EC of exposure = 5% of EAD, which is US$
100,000. Assume that the bank has set a RAROC hurdle rate of 15% and this transaction
has a net profit of US$ 12,000 before other adjustments.
REQUIRED:
1. Compute the bank’s risk-adjusted rate of return on the loan to an agricultural
company?
2. Now assume that the bank could also have made a loan for the same amount and
net profit of US$ 12,000 before other adjustments to a chemical manufacturing
firm, and that the EC = 2.5% in this case.
3. Which loan between the two should the bank grant and why?
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