Deck 7: Spot Lending and Credit Risk

Question 1

A short-term, unsecured borrowing that is backed by the issuer's credit strength is...

A)Bankers Acceptance
B)Commercial Paper
C)Repurchase Agreement
D)Federal Funds
E)Eurodollars

Answer 1

B

Question 2

The following is are) NOT characteristics of a mortgage loan:

A)the loan is usually illiquid
B)the loan's maturity date is certain
C)the loan is normally secured by the borrower's property
D)the interest rate can be fixed or variable
E)all of the above

Answer 2

B

Question 3

Which of the following statements is are) false?

A)Term loans require a repayment that is normally amortized.
B)Term loans have longer maturity as they are used to buy fixed assets that require large outlays.
C)The repayment comes from the cash flows generated by the assets financed by the term loans.
D)Term loans are not normally drawn under lines of credit.
E)All of the above.

Answer 3

D

Question 4

Which of the following statements is are) false?

A)A transaction loan is negotiated for a specific purpose.
B)A transaction loan is usually done frequently.
C)A transaction loan is normally secured by an asset.
D)The repayment comes from the use of the asset pledged as collateral
E)All of the above

Question 5

The "conditions precedent" in a loan agreement means

A)that a borrower must repay the loan before the due date
B)that a borrower must satisfy certain requirements before the loan is funded
C)that a bank can waive certain loan stipulations when the borrower has not defaulted
D)both a and b
E)both a and c

Question 6

Which of the following statements is are) false?

A)A working capital loan is used by firms to finance day-to-day operations.
B)A working capital loan is usually unsecured.
C)A working capital loan is usually used to buy current assets or repay debts incurred in purchasing current assets.
D)All of the above.
E)None of the above.

Question 7

When a bank originates a loan, it

A)initiates a contact with a borrower
B)conducts a credit analysis to determine the borrower's creditworthiness
C)designs the loan contract
D)collects the payments
E)a, b, and c only

Question 8

Representations in a loan agreement usually contain

A)borrower's legal status
B)the opinions of the borrower's counsel
C)borrower's collateral
D)all of the above
E)a and c only

Question 9

Bankers Acceptances are used in international trade mainly because...

A)they are a cheap source of financing
B)they always pay in local currency so there is no currency risk
C)they help solve informational asymmetry problem between the trading parties
D)they allow banks to earn a high profit
E)they are long-term borrowings

Question 10

A loan commitment is

A)a promise by the borrower to obtain a loan from a particular bank of his choice
B)a promise by the bank to lend in the future on a prespecified term.
C)an agreement that entitles the bank to change the interest rate on loan based on the prevailing market condition
D)the same as spot lending
E)all of the above

Question 11

In analyzing a loan application, a borrower's financial capability refers to...

A)capital
B)capacity
C)character
D)collateral
E)Conditions

Question 12

Credit card borrowings

A)are usually done on a short-term basis
B)are secured by the cardholders' assets
C)have a credit limit
D)all of the above
E)both a and c

Question 13

The main reasons) for the declining importance of the commercial and industrial loans relative to mortgage loans is

A)the competition from the venture capitalists
B)the S&L crisis which resulted in the reduction of mortgage lending of the remaining S&Ls
C)the bank's competitive advantage in solving private information problem has diminished
D)both a and b
E)all of the above

Question 14

Moral hazard problem associated with bank lending stems from

A)the borrower's private attributes which are unknown to the bank at the time of the loan application
B)the bank's inability to screen the borrower to determine its creditworthiness
C)the borrower's desire to take on riskier projects after obtaining the loan
D)all of the above
E)b and c only

Question 15

A loan covenant stipulates

A)that a borrower has filed all necessary tax returns before applying for a loan
B)certain minimum standards that a borrower must maintain to avoid a state of default
C)that a borrower must have a cosigner
D)all of the above
E)a and b only

Question 16

In credit card lending, the bank makes profits from

A)the discount at which the sales slips are sold to the merchants
B)the interest rate charged to the credit cardholders with outstanding balances
C)the annual fees that may be charged by the banks
D)all of the above
E)both b and c

Question 17

Risk processing involves

A)pre-lending screening
B)post-lending monitoring
C)loan workouts to control credit risk
D)all of the above
E)b and c only

Question 18

A bank loan acquired through a spot market purchase has the following characteristics:

A)the bank originates and then funds the loan
B)the bank promises to lend to a borrower on a prespecified terms in the future
C)the bank buys the loan from an intermediary that originated it
D)all of the above
E)a and c only

Question 19

An important difference between loans and debt securities is

A)loans are tradable, debt securities are not
B)loans are not tradable, debt securities are
C)loans are usually issued by banks, debt securities are not
D)loans are usually less liquid than debt securities
E)all of the above

Question 20

Bankers Acceptances

A)are financial instruments that arise to facilitate mostly international trade.
B)require a payment at face value at the maturity date.
C)are not tradable.
D)all of the above.
E)a and b only.

Question 21

Use the following information for questions
You are evaluating a loan request of $2.5 million from Dubious Corp.The firm has an existing debt repayment obligation of $5 million.It has $2.6 million of equity.The firm has two projects, A and B.An investment in A will yield a payoff of $5 million with probability
0.8 and $2.5 million with probability 0.2.Project B will yield a payoff of $8 million with probability 0.4 and zero with probability 0.6.The firm has assets-in-place that generates $6 million with probability 0.8 and zero with probability 0.2.Assume that the distributions of payoff from projects A and B are common knowledge, and the payoff from A is statistically independent of the payoff from B.However, as a bank lending officer, you cannot observe the firm's project choice.
Under the assumption that the firm doesn't have equity capital and the loan is priced assuming that A is chosen, what will be the expected value of equity if the firm switches to project B?

A)$4.16 million
B)$3.56 million
C)$2.36 million
D)$1.90 million
E)$1.88 million

Question 22

Use the following information for questions
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
Suppose a secured loan is offered.How much collateral should you ask the borrower round to the nearest decimals)?

A)$1.41 million
B)$1.23 million
C)$0.87 million
D)$0.65 million
E)$0.50 million

Question 23

Use the following information for questions
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
Suppose that you assume B will be chosen, and offer an unsecured loan.What project will the firm choose and what is the interest rate?

A)Project A with net expected payoff $4.05 million, interest rate 83.33%
B)Project A with net expected payoff $2.35 million, interest rate 83.33%
C)Project A with net expected payoff $2.07 million, interest rate 120%
D)Project B with net expected payoff $2.35 million, interest rate 120%
E)Project B with net expected payoff $4 million, interest rate 120%

Question 24

When capital can be used as a signal of project quality, a good borrower is charged a low interest rate.The reason that a high risk borrower is unwilling to put up more equity despite this low rate is...

A)low rate induces the high risk borrower to take on less risky project
B)the high risk borrower is more interested in getting debt tax shield, and therefore would like as large a loan as possible
C)the high risk borrower can lose most of its capital when a low rate is charged
D)all of the above
E)a and c only

Question 25

Use the following information for questions
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
What is the interest rate for the secured loan?

A)120%
B)83.33%
C)57.33%
D)27.08%
E)15.75%

Question 26

A borrower's capital is an important factor in credit analysis because...

A)higher amount of capital mitigates moral hazard problems
B)higher amount of capital signals the borrower's confidence about its future cash flows
C)the greater is the amount of capital, the greater is the borrower's loss if it decides to take on riskier projects
D)all of the above
E)b and c only

Question 27

Use the following information for questions
You are evaluating a loan request of $2.5 million from Dubious Corp.The firm has an existing debt repayment obligation of $5 million.It has $2.6 million of equity.The firm has two projects, A and B.An investment in A will yield a payoff of $5 million with probability
0.8 and $2.5 million with probability 0.2.Project B will yield a payoff of $8 million with probability 0.4 and zero with probability 0.6.The firm has assets-in-place that generates $6 million with probability 0.8 and zero with probability 0.2.Assume that the distributions of payoff from projects A and B are common knowledge, and the payoff from A is statistically independent of the payoff from B.However, as a bank lending officer, you cannot observe the firm's project choice.
What is the interest rate charged assuming that A is chosen and the firm has no equity?

A)0%
B)4%
C)25%
D)51%
E)65%

Question 28

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
If an unsecured loan is offered and you assume that Mr.Brown will choose high effort level, what is the unsecured loan interest rate?

A)15%
B)25%
C)37.5%
D)50%
E)250%

Question 29

Use the following information for questions
You are evaluating a loan request of $2.5 million from Dubious Corp.The firm has an existing debt repayment obligation of $5 million.It has $2.6 million of equity.The firm has two projects, A and B.An investment in A will yield a payoff of $5 million with probability
0.8 and $2.5 million with probability 0.2.Project B will yield a payoff of $8 million with probability 0.4 and zero with probability 0.6.The firm has assets-in-place that generates $6 million with probability 0.8 and zero with probability 0.2.Assume that the distributions of payoff from projects A and B are common knowledge, and the payoff from A is statistically independent of the payoff from B.However, as a bank lending officer, you cannot observe the firm's project choice.
Suppose that after receiving the loan, the firm considers investing in B under the assumption that project A would be chosen).Is this moral hazard problem going to benefit the firm's shareholders?

A)Yes, since the expected value of equity in project B is $4.40 million which is more than $4.16 million with project A.
B)Yes, since the expected value of equity in project B is $4.16 million which is more than $3.60 million with project A.
C)No, since the expected value of equity in project B is $4.16 million which is less than $4.40 million with project A.
D)No, since the expected value of equity in project B is $3.60 million which is less than $4.16 million with project A.
E)No, since the expected value of equity in project B is $3.60 million which is less than $4.40 million with project A.

Question 30

The following may trigger acceleration clauses in default provisions:

A)impairment of collateral
B)change in management or ownership
C)failure to make timely payments
D)b and c only
E)all of the above

Question 31

When capital is used as a screening device in conjunction with interest rate, a high risk borrower chooses a contract with__________ , while a low risk borrower chooses the one with_______ .

A)high capital-high interest rate, low capital-low interest rate
B)low capital-low interest rate, high capital-high interest rate
C)high capital-low interest rate, low capital-high interest rate
D)low capital-high interest rate, low capital-low interest rate
E)low capital-low interest rate, high capital-low interest rate

Question 32

The following is an example of restrictive clauses:

A)a borrower must maintain certain level of working capital
B)a borrower cannot pay excessive amount of dividends
C)a borrower must invest in specific type of fixed investments
D)a and b only
E)b and c only

Question 33

Use the following information for questions
You are evaluating a loan request of $2.5 million from Dubious Corp.The firm has an existing debt repayment obligation of $5 million.It has $2.6 million of equity.The firm has two projects, A and B.An investment in A will yield a payoff of $5 million with probability
0.8 and $2.5 million with probability 0.2.Project B will yield a payoff of $8 million with probability 0.4 and zero with probability 0.6.The firm has assets-in-place that generates $6 million with probability 0.8 and zero with probability 0.2.Assume that the distributions of payoff from projects A and B are common knowledge, and the payoff from A is statistically independent of the payoff from B.However, as a bank lending officer, you cannot observe the firm's project choice.
Suppose that the firm doesn't have equity capital.As a lending officer, what is the repayment obligation that you require to break-even, assuming that project A will be undertaken?

A)$2.5 million
B)$2.6 million
C)$3.125 million
D)$3.765 million
E)$4.125 million

Question 34

Use the following information for questions
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
Suppose you assume that A will be chosen, and offer an unsecured loan.What project will the firm choose and what is the interest rate?

A)Project A with net expected payoff $6.75 million, interest rate 10%
B)Project A with net expected payoff $2.4 million, interest rate 83.33%
C)Project A with net expected payoff $2.25 million, interest rate 57%
D)Project B with net expected payoff $2.625 million, interest rate 83.33%
E)Project B with net expected payoff $4 million, interest rate 57%

Question 35

To comply with affirmative covenants,

A)a borrower must not discriminate less risky projects from more risky ones
B)a lender must not discriminate borrowers based on race
C)a borrower is required to furnish the lender with periodic financial statements
D)a lender must charge all borrowers the same interest rate
E)all of the above

Question 36

Use the following information for questions
You are evaluating a loan request of $2.5 million from Dubious Corp.The firm has an existing debt repayment obligation of $5 million.It has $2.6 million of equity.The firm has two projects, A and B.An investment in A will yield a payoff of $5 million with probability
0.8 and $2.5 million with probability 0.2.Project B will yield a payoff of $8 million with probability 0.4 and zero with probability 0.6.The firm has assets-in-place that generates $6 million with probability 0.8 and zero with probability 0.2.Assume that the distributions of payoff from projects A and B are common knowledge, and the payoff from A is statistically independent of the payoff from B.However, as a bank lending officer, you cannot observe the firm's project choice.
Suppose the firm has the $2.6 million equity and you assume that project A will be chosen.What interest rate will you charge in order to break-even?

A)3%
B)4%
C)8.5%
D)10%
E)12.4%

Question 37

Use the following information for questions
National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank.
Given that a secured loan is offered, what is the borrower's net expected payoff from choosing project A? Project B?

A)Project A = $0.09 million, Project B = $0.58 million
B)Project A = $2.34 million, Project B = $2.34 million
C)Project A = $2.34 million, Project B = $1.68 million
D)Project A = $0.58 million, Project B = $1.68 million
E)Project A = $1.68 million, Project B = $1.68 million

Question 38

The reason why character is an important consideration in a loan request is that...

A)a good borrower always chooses a higher interest rate to distinguish itself from a bad one
B)a good borrower always chooses a lower interest rate to distinguish itself from a bad one
C)a borrower's credit reputation is a good indication of its incentive to default
D)a good borrower has more collateral to pledge
E)all of the above

Question 39

When collateral is used as a screening device in conjunction with interest rate, a high risk borrower chooses a contract with , while a low risk borrower chooses the one with .

A)high collateral-high interest rate, low collateral-low interest rate
B)low collateral-low interest rate, high collateral-high interest rate
C)high collateral-low interest rate, low collateral-high interest rate
D)low collateral-high interest rate, low collateral-low interest rate
E)low collateral-high interest rate, high collateral-low interest rate

Question 40

The use of collateral in bank lending can

A)induce the borrower to provide inadequate effort to manage a project
B)induce the borrower to overinvest
C)reduce moral hazard problem
D)all of the above
E)a and c only

Question 41

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
Given the structure of the secured loan, which loan would he prefer and what is the net payoff associated with that choice?

A)Unsecured, net payoff = $95.00
B)Unsecured, net payoff = $96.52
C)Unsecured, net payoff = $100.00
D)Secured, net payoff = $96.83
E)Secured, net payoff = $105.77

Question 42

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
If you offered an unsecured loan and assumed that low effort will be chosen, what effort level will Mr.Brown choose and what is the net payoff associated with that choice?

A)High effort, net payoff = $75
B)High effort, net payoff = $58
C)Low effort, net payoff = $0
D)Low effort, net payoff = $95
E)Low effort, net payoff = $133

Question 43

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
If a secured loan is offered instead, what will be the interest rate on the loan to induce Mr.Brown to expend high effort round to the nearest decimal)?

A)50%
B)37.5%
C)22.37%
D)20.83%
E)15.21%

Question 44

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
If an unsecured loan is offered by the bank assuming that high effort level will be chosen, what is the Nash Equilibrium for Mr.Brown and what is the net payoff associated with his choice?

A)Choose high effort, its payoff = $122.50
B)Choose high effort, its payoff = $ 100
C)Choose low effort, its payoff = $125
D)Choose low effort, its payoff = $ 175
E)Choose low effort, its payoff = $198.75

Question 45

Use the following information for questions
Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort.
With a secured loan and to induce Mr.Brown to strictly choose high effort level, what should be the amount of collateral?

A)$91.75
B)$86.57
C)$75.68
D)$43.84
E)$36.88