Question

Chariot Bank has begun making small loans to students. All students who get the loan receive exactly the same amount of money. Students pay back the loan in quarterly installments beginning 1 quarter from now. The loans are 2.5 - year loans that require the student make 10 quarterly payments of $200 each. The $200 quarterly payment covers the repayment of principal as well as interest.

Assume for this exercise that Chariot Bank makes 30 loans. The loans are ranked according to the estimated credit risk of the students. Eight of the 30 students are deemed to have high credit risk; the remainder has average credit risk. Rather than holding the 30 individual loans, the Bank pools together the cash flows together and create 4 financial securities (CSLs) from the cash flows. These securities are:

I) CSL-H. The owner of this security receives the pooled cash flows from the 8 high-risk loans only. They receive all the payments over all the time periods.

II) CSL-A. The owner of this security receives the pooled cash flows from the 22 average credit risk loans. From those loans, they receive all the payments for quarters 1 and 2; no payments in quarters 3 through 10.

III. CSL-B. The owner of this security receives the pooled cash flows from the 22 average credit risk loans. From these loans, they receive all the payments for quarters 3 through 8. They receive no payment in quarters 1 and 2 and no payments in quarters 9 and 10.

IV. CSL-C. The owner of this security receives the pooled cash flows from the 22 average credit risk loans. From these loans, they receive all the payments for quarters 9 and 10. They receive no payments in quarters 1 through 8.

Given the above information answer the following questions.

A. Which security has more interest rate risk CSL-B or CSL-C? Explain

B. Does security CSL-A have interest rate risk?> Explain why or why not.

C. Assume all of the 4 securities trade on a secondary market and investors have access to up-to-the-minute data on the price of those securities. Do the 4 securities have market risk? Explain

D. Do the CSL-A, CSL-B or CSL-C securities have credit risk? Explain.

E. How does selling on the secondary market alter the liquidity risk of the securities and does it impact the rate of return investors require on the securities.? Explain.

F. Would the rate of return be higher on CSL-A or CSL-C? Explain.

Answer 1

A. Which security has more interest rate risk CSL-B or CSL-C? Explain

Answer)The interest rate Risk increase with time , i.e a longer tenure security has higher chance to increase the in interest rate.

So, CSL-C is getting money at end of 9-10 quarters has higher amount of interest rate risk.

B. Does security CSL-A have interest rate risk?> Explain why or why not.

Answer) Although the security CSL-A recieving payment from 1-2 quarter , the amount of interest rate risk is low .

C. Assume all of the 4 securities trade on a secondary market and investors have access to up-to-the-minute data on the price of those securities. Do the 4 securities have market risk? Explain.

Answer) with the concept of efficient market , the trading and infoemation access will reduce the market risk in such situation.

D.Do the CSL-A, CSL-B or CSL-C securities have credit risk? Explain.

Answer) Yes, although the payment is coming from pooled cash flows from the 22 average credit risk loans. There are some probability of default in payment . Credit risk persists in all investment.  

E. How does selling on the secondary market alter the liquidity risk of the securities and does it impact the rate of return investors require on the securities.? Explain.

Answer) The trading in seconary market , provide opportunity to holders to sell the security in market as and when required , increase the liquidity . The liquid stock requires less return in comparision to the illiquid stocks.

F. Would the rate of return be higher on CSL-A or CSL-C? Explain.

Answer) Rate of return should have direct relation with amount of risk , CSL_C has comparetively high amount of risk . The return in the security should be higher.