Question

A financial institution is charging a 13 percent interest rate on a $15,000,000 loan. The bank also charged $150,000 in fees to originate the loan. The bank has a cost of funds of 9 percent. The borrower has a five percent chance of default, and if default occurs, the bank expects to recover 90 percent of the principal and interest. What is the risk of the loan using the Moody's Analytics model? Briefly discuss the importance of this model.

Answer 1

EDF = expected default frequency = probability of default = 5%

Recovery on default = R = 90%

Loss given default, LGD = 1 - R = 1 - 90% = 10%

Risk of the loan

= 6.89%

==========

Importance of the Model:

Moody Analytics Model is a credit risk model that aims to quantify the expected return and risk of a portfolio of a portfolio of loans. It pulls together various characteristics of a loan to quantify loss from a loan. This model is widely used by portfolio managers, banks, non banking finance companies to assess the expected return and riskiness of their loan portfolios. We can understand about the model further. Prior to that, let's familiarize with the following terms:

AIS = Annual all-in-spread = Annual fees collected by the lender + the loan rate charged to the borrower - the cost of loan applicable to the lender

EDF = measure of probability of default =probability of default = expected default frequency

LGD = Loss given default

Loss from loan = Expected loss on the loan in case of default = probability of default x LGD = EDF x LGD

The KMV model thus has three components:

1. Expected return on a loan: This is measured by = AIS - Loss from Loan = AIS - EDF x LGD
2. Risk on a loan =
3. Correlation between different loans given to the borrower

This model therefore, successfully quantifies the expected return and risk of a portfolio of a portfolio of loans