Question

2. Carter Bank makes a 3-year loan for $1,000 with an annual coupon rate of 8%.

Suppose Carter Bank lends to Alex at a 10% annual coupon, which is 2% above the Treasury risk-free rate. Name an embedded borrower risk that Carter may have included in the mark-up above the initial risk-free rate, and suggest an approach that it could have used to price that embedded risk.

Answer 1

The given question can be analysed in the following manner:

Given data:

Term - 3 years

Principal - $ 1000

Interest rate - 0.08

Calculation of Total Loan Amount: Assumption - Calculation based on Simple Interest rate

Loan Amount = Principal + Interest = 1000 + (1000 * 0.08)^3 = $1240

If the Interest rate is 10%:

Loan Amount = Principal + Interest = 1000 + (1000 * 0.1)^3 = $1300

Differential Amount = 1300 - 1240 = $60

There is a risk associated for the Investor in terms of higher interest.

Therfore, the investor can approach for an Option Contract with Carter Bank.