For analyzing the “credit risk” of a bank’s loan to private borrowers, which of following is the best description of the loan ? For the bank, the loan represents positions that are : A. long a risk-free bond and long a put B. long a risk-free bond and short a put C. short a risk-free bond and long a put Pick up one & give your reason.
It’s B. “Long a bond” should be obvious. Short put is because the customer might default (i.e. customer has the option of not paying the loan).
B. Long risk free bond because the bank has invested and expect payment. If it is a short the bank collects cash upfront for the transaction. This is the “best description for the loan”, which is different from deposits which were used to fund the loan (which is a short). It is also a short put because the borrower can decide to pay back the loan at anytime.
If you’re long a loan your downside is that the entire loan is lost ( the issuer has no chance of repaying ) , just like Shot Put. The downside is limited .
janakisri Wrote: ------------------------------------------------------- > If you’re long a loan your downside is that the > entire loan is lost ( the issuer has no chance > of repaying ) , just like Shot Put. The downside > is limited . I can’t make the connection between your post and the question asked…
The correct answer is B and the relevant statements are on P.252 of CFAI text Vol 5. The bondholders (here, the bank) of a company is equivalent to long a default-free zero-coupon bond and short a put. On the other hand, it seems the stockholders of a company is equivalent to LONG a call on the company’s asset (please refer to P.250~251). I am not very sure about this, can anyone confirm ?
I agree with me.taga: Ans is B - for the reasons provided. If you are short a put the downside is limited, but limited to 100% of the loan amount. meaning you could lose all of the capital invested, but not more than that (unlike a short call).
me.tega Wrote: ------------------------------------------------------- > B. > > Long risk free bond because the bank has invested > and expect payment. If it is a short the bank > collects cash upfront for the transaction. This is > the “best description for the loan”, which is > different from deposits which were used to fund > the loan (which is a short). > > It is also a short put because the borrower can > decide to pay back the loan at anytime. Nice. I would’ve totally flunked this one.