Question

What risk premium will a financial institution require on a $25 million loan given the following information:

the financial institution needs an expected return of 6.75% in order to generate the desired profit for its investors;

the expected default rate on loans of this type is 3%;

if the borrower defaults on the loan, the financial institution expects to recover 70% of the total return;

the financial institution’s base rate covers its costs of funds (2.5%) and overhead (2%);

the lender charges an origination fee of 0.375% of the loan amount; and the lender requires the borrower to maintain a compensating balance in an amount equal to 5% of the loan balance in an interest bearing certificate during the full term of the loan.

Answer 1

Soln : Total amt. of loan = $25 million, Expected return to be provided = 6.75% , So, total value of interest per year = 6.75%*25 = $1.6875 mn, Now, effective interest rate to the borrower to be calculated based on compensating balance.

Compensating balance = 5% of loan amount, total amount received by borrower = 95% of loan value

Effective interest rate = Interest paid/effective loan received by borrower = 1.6875/95%*25 = 7.105%

Default rate = 3%, Recovery from default loan = 70%, Net loss = 3%*70% = 0.021 = 2.1%

Cost of funds = 2.5% +2% = 4.5% ,

So, Total cost of funds = 4.5% + 2.1% = 6.6%

Net risk premium to be charged over cost of funds = 7.105% - 6.60 = 0.505%