Part 3: CAPITAL STRUCTURE IN BANKS

Question 3.1

The following simplified credit rating transition matrix (aka, migration matrix) displays one-
year conditional probabilities for only two credits (A and B). For example, the A-rated credit
has an 80.0% probability of remaining A-rated at the end of the year, and a 20.0% probability
of being downgraded to B-rated, but is not expected to default within one year. From year to
year, migrations are independent; i.e., the matrix satisfies the Markov property.

Transition Matrix

A B D

A 80% 20% 0%

B 10% 70% 20%

D 0% 0% 100%

A bank has extended a three-year $15.0 million loan to a B-rated corporate borrower. The
bank assumes the exposure at default (EAD) is the principal amount of $15.0 million and
estimates a 40.0% recovery rate. If the relevant default probability is the three-year
cumulative default probability, then what is the expected loss (EL)?

Question 3.2

A credit portfolio contains an adjusted exposure of $30.0 million with a default probability of
4.0%. In regard to loss given default (LGD), the Portfolio Manager estimates an (LGD) of 40.0%
with a standard deviation, σ(LGD), of 40.0%. What is the position's unexpected loss (UL)?

Question 3.3

A bank's credit exposure to a customer consists of the following: Exposure amount (EA) is
$50.0 million Probability of default (PD) is 2.0% Loss rate (LR; aka, loss given default) is 50.0%
Standard deviation of loss rate is 40.0% The expected loss (EL) of this exposure is $500,000 =
$50.0 million * 2.0% * 50%. Which is nearest to the exposure's unexpected loss (UL)?

Question 3.4

A bank has extended two loans to customers in the same industry. Both loans have an
exposure amount (EA) of $50.0 million, default probability (PD) of 2.0%, loss rate (LR) of 50.0%,
and standard deviation of loss rate of 60.0% such that each loan has an expected loss of
$500,000 and an unexpected loss of $5.5 million, In this way, the bank's credit portfolio
consists of these two credit assets; and the default correlation between the two loans is 28.0%.
Which is nearest to the risk contribution of each asset to the portfolio's unexpected loss?

Part 4: RATING ASSIGNMENT METHODOLOGIES

Question 3.5

Given the following one-year transition matrix, what is the probability that a B rated firm will default
over a two-year period?

Rating to
Rating from
A B C Default

A 90% 5% 5% 0%

B 5% 80% 7% 8%

C 4% 8% 70% 18%

1. what is the probability that a B rated firm will default over a two-year period?

2. what is the probability that a B rated firm doesn’t fall into any lower rating category at any time
over a two-year period?

Question 3.6

Given the following one-year transition matrix, what is the probability that a Ba rated firm will
default over a two-year period?

Rating Rating to
from Aaa Aa A Baa Ba B Caa-C Default

Aaa 92.00% 7.00% 0.80% 0.20% 0.02% 0.02% 0.00% 0.00%

Aa 1.32% 90.71% 6.92% 0.75% 0.19% 0.04% 0.01% 0.06%

A 0.08% 3.02% 90.24% 5.67% 0.76% 0.12% 0.03% 0.08%

Baa 0.05% 0.33% 5.05% 87.50% 5.72% 0.86% 0.18% 0.31%

Ba 0.01% 0.09% 0.59% 6.70% 82.58% 7.83% 0.72% 1.48%

B 0.00% 0.07% 0.20% 0.80% 7.29% 80.62% 6.23% 4.79%

 Caa-C 0.00% 0.03% 0.06% 0.23% 1.07% 7.69% 75.24% 15.68%

Question 3.7

In the Merton approach to credit risk, default probability is given by this function (note the
formula in De Laurentis is incorrect and should be given as follows):

ln (F) − ln (V) − (μ − 0.5𝜎 2 )T

𝑃𝐷 = 𝑁( )
σ√𝑇

Let us make the following assumptions:

The firm's asset value, V(A), is $1.0 billion

The expected asset return, p, is 15.0%

The volatility of the assets, σ(A), is 25.0%

The face value of debt, F, is $500.0 million

The debt matures in four years; i.e.., T = 4.0 years

Which is nearest to the default probability (PD) estimated by Merton?