The third and last interview is with Ms Bennett, the credit risk expert. The purpose of this interview is to evaluate your familiarity with credit risk assessment and computation.

Assume you work for a bank, which has granted a loan to a manufacturing business. This loan will be paid back in a single payment of $135 million. The business has an estimated 3% chance of defaulting over the life of the loan. Your investigations indicate that, in the case of default, the net recovery value of the loan would be 70% after a decision from the bankruptcy courts. The bank is required to hold a credit reserve equal to the expected credit loss.

 

(a) Compute the credit reserve on the bank's loan.

 

Another borrower has a constant probability of default of 3% per year. You should consider that the probability of survival is the invert of the probability of default over time, a.k.a. cumulative probability of default.

 

(b)  Compute the probability of default of the company after four years from now.
 

(c)  Compute the optimal loan maturity (in years or months) to limit the probability of default to 10% over the period.