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: a. Compute the bank's risk-adjusted rate of return on the loan to an agricultural company? [6 marks] b. 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. [8 marks] c. Which loan between the two should the bank grant and why?

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a To compute the banks riskadjusted rate of return on the loan to an agricultural company using th... View the full answer