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A bank is planning to make a loan of $5 000 000 to a firm in the steel industry. It expects to charge an up-front fee of 1.5 per cent and a servicing fee of 50 basis points. The loan has a maturity of 8 years and a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 per cent. Assume the bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 per cent, based on two years of historical data. The current market interest rate for loans in this sector is 12 per cent.
Problem (i) Using the RAROC model, estimate whether the bank should make the loan.
Problem (ii) What should be the duration in order for this loan to be approved?
Problem (iii) Assuming that duration cannot be changed, how much additional interest and fee income would be necessary to make the loan acceptable?
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