Lesson 6: Individual Loan Risk

Question 1

Identify and define the borrower-specific and market-specific factors that enter into the credit decision.

What is the impact of each type of factor on the risk premium?

Answer 1

The borrower-specific factors are:

Reputation: Based on the lending history of the borrower; better reputation implies a lower risk
premium.

Leverage: A measure of the existing debt of the borrower; the larger the debt, the higher the risk premium.

Volatility of earnings: The more stable the earnings, the lower the risk premium.

Collateral: If collateral is offered, the risk premium is lower.

Market-specific factors include:

Business cycle: Lenders are less likely to lend if a recession is forecasted.

Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions.

Question 2

Suppose there were two factors influencing the past default behaviour of borrowers: the leverage or debt-
assets ratio (D/A) and the profit margin ratio (PM). Based on past default (repayment) experience, the linear probability model is estimated as: 

PDi=0.105(D/Ai) - 0.35(PMi)

Prospective borrower A has a D/A =0.65 and a PM = 5%, and prospective borrower B has a D/A = 0.45 and
PM =1%.

Calculate the prospective borrowers’ expected probabilities of default (PDi). Which borrower is the better loan candidate? Explain your answer.

Answer 2

PDA = 0.105(0.65) - 0.35(0.05) = 0.05075 or 5.075%

PDB = 0.105(0.45) - 0.35(0.01) = 0.04375 or 4.375%

Prospective borrower B is the better loan candidate. Even though B’s profit margin is lower than A’s, A’s higher debt-asset ratio increases the firm’s probability of default to be higher than firm B’s.