Question

(a) Michael Bank has a portfolio which consists of two loans. The details of the loans are:

Loan 1: amount is $3,000,000, expected return is 10%, and standard deviation of returns is 10%.

Loan 2: amount is $500,000, expected return is 12%, and standard deviation of returns is 20%.

The correlation coefficient between the two loans is 0.15. Based on the Modern Portfolio Theory, compute the expected rate of return and standard deviation of this loan portfolio.

(b) Explain the major difference between structured investment vehicle and special purpose vehicle.

Answer 1

Total expected return = 300000* 10/800000 + 500000* 12/800000 = 11.25 %

We have calculated the above answer by weighted average method.

Now, we have to calculate the std deviation of the loan portfolio.

It shall be calculated as follows :

SD = [ (Wa*SDa)^2 + (Wb*SDb)^2 + Rab* Wa*SDa * Wb*SDb ] ^ 1/2

Where Wa and Wb are weights of Loan 1 and loan 2 and SDa and SDb are standard deviation of Loan 1 and 2 and Rab is co relation between loan 1 and 2.

= [(0.375*10)^2 + (0.625* 20) ^ 2 + 0.15* 0.375*10* 0.625* 20 ] ^1/2

= 13.31%

Now the answer to the second part is

The SPV earns by the fact that they make a separate company and also they take the stressed assets and earns by restructuring the stressed assets while the Structured investement vehicle earns by the fact of difference between the interest rates of short term and long term debts. They are the Gap Earners.