Answer the following questions in short answers

FI (financial institution )

Instructions:-

Answer the following questions in short answers – answering with concise answers to the questions:

Question 1

  1. Why is the market value of equity a better (than book value) measure of a financial institution (FI)’s ability to absorb losses?
  2. is the structure of the balance sheet or general insurers different to the structure of life office?
  • Differentiate between secured loan and an unsecured loan. Why would FI prefer to charge floating rates, especially for longer maturity loans?

Question 2

  1. Provide two motivations why financial institutions are prepared to expose to off-balance-sheet risk. How are the off-balance-sheet risk activities of financial institutions being monitored by the regulators?
  2. Suppose an FI plans to issue some certificate of deposits (CDs) 3-months from today. As part of their interest risk hedging strategy, they purchased an interest rate forward contract (FRA) at 4.9%p.a. At the time the FI issue the CDs, they were able to issue at 3.5%pa. What will happen to the FRA contracts?

Question 3

How is an FI exposed to interest rate risk when it makes loan commitments? How can FI control for this risk?

  1. How do standby letters of credit (SLC) differ from documentary letters of credit? What other types of FI products do SLCs compete?
  2. In each of the following cases, indicate whether it would be appropriate for an FI to buy or sell forward contract to hedge the appropriate risk
  3. A commercial bank plans to purchase 10 year bond in three months
  4. An insurance company plans has an asset with duration of six years and liabilities with duration of 13 years.
  5.  

Question 4

  1. In what ways can FI use loans sales and securitisation to manage credit risk?
  2. How does liquidity risk arising from liability side of the balance sheet of a FI, differ from liquidity risk arising from the asset side of the balance sheet?
  3. What are the costs and benefits to a financial institution of holding large amount of liquid assets? What concerns motivate regulators to require deposit taking institutions to hold minimum amounts of liquid assets??

Question 5

  1. Discuss some of the conclusions from the empirical studies on the economies of scales and X-efficiencies on the banking sector?
  2. Explain how technological improvements can increase an FI’s interest and non-interest income. Provide appropriate examples.
  3. What are the ways in which deposit institutions can offset the liquidity of a net deposit drain of funds? What are the operational benefits and costs of each method?

Question 6

  1. Does the interest rate risk measured in Value-at-Risk (VaR) capture the same activities of the bank, as the maturity gap or the repricing gap do? Besides interest rate risk, what other risks do VAR measures?
  2. One of approaches commonly used in the estimation of VaR is the back simulation. Discuss some of the shortcomings in the estimation of this approach.
  3. What conditions were introduced by Bank of International Settlements (BIS) to allow large banks to use internally generated models for the measurement of market risk? What types of capital can be held to meet the capital charge requirements?

Question 7

  1. What are the main differences between the assets, liabilities and income of an investment bank and a life insurance company? Why such differences exist?
  2. Discuss some reasons why in the recent decades Australian financial institutions have gradually less dependent upon retail deposits as their major source of funding.

Question 8

  1. Provide two motivations why financial institutions are prepared to expose to off-balance-sheet risk. How are the off-balance-sheet risk activities of financial institutions being monitored by the regulators?
  2. What moral hazard issues must a financial institution (FI) take heed of when making loan sales and securitisation?
  3. Why is it difficult for small banks, credit unions and building societies to measure credit risk using modern portfolio theory?

Question 9

  1. What are the two advantages of using futures contracts as a risk hedging tool?
  2. Bank 1 can issue five-year CDs at a fixed rate of 11 percent or at a variable rate of LIBOR plus 2 percent. Bank 2 can issue five-year CDs at fixed rate of 13 percent fixed or at a variable rate of LIBOR plus 3 percent.
  3. Discuss the potential motivation to enter into a swap transaction between the two banks
  4. Based on the information above what a feasible swap?
  5. If a borrower intends to raise fund from the 90-day bank bill market, how can the borrower create
    a fixed rate for the length of the loan by using the forward rate agreement (FRA)?
  6. As a risk manager of at a medium size financial institution, what risk you potentially have exposed to if the bank wishes to liquidate some of the Treasury securities next month? How do you use option to hedge against that particular exposure?

Question 10

  1. What is repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity?
  2. What is the duration of a bond with three years to maturity; if it has a face value of $1000 and pays 6 per cent annual coupon per annum. The current yield to maturity for bonds with similar risk and maturity are trading at 4.75% per annum.
  3. What are the costs and benefits to a financial institution of holding large amount of liquid assets? Why are Treasury securities considered good examples of liquid assets?

Question 11

  1. Discuss some of the conclusions from the empirical studies on the economies of scales and X-efficiencies on the banking sector?
  2. What actions have the BIS taken to protect depository institutions from insolvency due to operational risk?
  3. What are the ways in which deposit institutions can offset the liquidity of a net deposit drain of funds? What are the operational benefits and costs of each method?

Question 12

  1. Does the interest rate risk measured in Value-at-Risk (VaR) capture the same activities of the bank, as the maturity gap or the repricing gap do? Besides interest rate risk, what other risks do VAR measures?
  2. One of approaches commonly used in the estimation of VaR is the back simulation. Discuss some of the shortcomings in the estimation of this approach.
  3. What conditions were introduced by Bank of International Settlements (BIS) to allow large banks to use internally generated models for the measurement of market risk? What types of capital can be held to meet the capital charge requirements?
  4. Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = 0.03X1 + 0.02X2 – 0.05X3 + error, where X1 is the borrower’s debt/equity ratio, X2 is the volatility of borrower earnings, and X3 = 0.10 is the borrower’s profit ratio. For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 = 0.10.
  5. What is the projected probability of default of the borrower?
  6. List the weaknesses of this type of linear probability model?

Solution

Answer the following questions in short answers

Question 1

  1. Why is the market value of equity a better (than book value) measure of a financial institution (FI)’s ability to absorb losses?
  • In the event of bankruptcy, it’s the market value, and not the book value of assets of a financial institution, which would be used to settle creditors. This is because the market value is that value that assets would fetch in the market if they were disposed.
  • is the structure of the balance sheet or general insurers different to the structure of life office?
  • Unlike a general insurance where claims are settled against premiums received (liabilities) in a relatively short period of time (within one year) to determine the net income from such premiums, a life office balance sheet requires long periods of time from the time premiums are received to the time claims are paid. As a result, liabilities in life office balance sheet are an actuarial estimate that enables the profitability and solvency of the business to be determined. Otherwise, unlike a general business, such liabilities cannot be determined with absolute certainty (Horton, J. & Macve, R., 1996).
  • Differentiate between secured loan and an unsecured loan. Why would FI prefer to charge floating rates, especially for longer maturity loans?
  • A secured loan is one that is only obtained after one gives a security (asset) as security to back the loan. For example, for a mortgage loan, a house is used as the asset that backs the loan. The asset is used as the collateral. Unsecured loans, on the other hand, do not require any assets to be used as collateral. The lender has no opportunity to seize the properties of the one offered the loan to pay back the loan. An example is the student loan since there are no assets tied to the loan (Irby, L., 2016). In secured loans, the borrowers can get higher loans limit approvals and they can have longer repayment periods. They also usually have lower interest rates due to the lower risk to the lender as a result of the presence of the collateral.
  • To get a better match for their liabilities, most financial institutions prefer floating interest rates. The rates must be correlated with the rate such institutions have to pay on its deposits (Frank, J, Fabozzi, C.F.A. & Ramsey, C., 1999). For longer maturity loans, the floating interest rates help in covering for the risk of depreciation on the asset tied as collateral.

Question 2

  1. Provide two motivations why financial institutions are prepared to expose to off-balance-sheet risk. How are the off-balance-sheet risk activities of financial institutions being monitored by the regulators?
  1. By exposing to off balance sheet risk, Financial institutions are motivated by the desire to increase fees income by narrowing the spread in their borrowings
  2. They are also motivated by the desire to avoid regulatory costs that would otherwise reduce their reported earnings. They are not subject to capital requirements
  3. Off balance sheet activities are monitored by regulators through a requirement that they report five of their off balance sheet activities in each quarter.  These must be included under the Schedule L section of the Call report after the introduction of Basle II,
  • Suppose an FI plans to issue some certificate of deposits (CDs) 3-months from today. As part of their interest risk hedging strategy, they purchased an interest rate forward contract (FRA) at 4.9%p.a. At the time the FI issue the CDs, they were able to issue at 3.5%pa. What will happen to the FRA contracts?
  • The FRA would still generate a 1.4% (4.9-3.5%) profit since the futures contract was meant to protect the FI from interest-rate risk.

Question 3

How is an FI exposed to interest rate risk when it makes loan commitments? How can FI control for this risk?

  • Once a bank commits to a fixed-rate loan, it is faced with the possibility of increments in interest rates in the span of the intervening period. In case the loan is taken down by the borrower, the risk lowers the FI’s net interest income. The loan can be partly counterbalanced by the bank through committing to loans through variable rates.
  • How do standby letters of credit (SLC) differ from documentary letters of credit? What other types of FI products do SLCs compete?
  • Documentary letters of credit pertains the performance of the lender while the standby letter of credit (SLC) covers the default of the buyer. In SLC, the bank issuing the loan will be obliged to perform if the buyer fails to perform or defaults the loan. A documentary letter of credit is used to assure the borrower that the bank will provide him or her with the requested amount.
  • Apart from LCs, there are also bank guarantees, which are used whenever any of the parties fails to honor their agreement.
  • In each of the following cases, indicate whether it would be appropriate for an FI to buy or sell forward contract to hedge the appropriate risk
  • A commercial bank plans to purchase 10 year bond in three months

Sell forward contract so as to protect itself against any possibility of an increase in interest rates.

  • An insurance company plans has an asset with duration of six years and liabilities with duration of 13 years.

Buy forward contract so as to protect against a decline in interest rates

Question 4

  1. In what ways can FI use loans sales and securitization to manage credit risk?
  • Securitization enables a financial institution to alter its product base, and therefore reducing the risks of the resultant portfolio without alienating or changing their customer base
  • Securitization also enables financial institutions to manage its interest rate risk exposure by matching assets and liability durations by enabling the financial institution to determine which loans can be packaged and subsequently sold off.
  • A financial institution may conduct a loan sale by originating a loan and selling it without recourse to an external buyer. In this case, the FI removes the loan from its balance sheet, and also delivers itself from the explicit liability in case the loan goes bad eventually.
  • Loan securitization can be done through collateralized mortgage obligation, pass-through security, and mortgage-backed bonds. Securitization can help in making sure that the lenders get collaterals for all the loans that they have offered.
  • How does liquidity risk arising from liability side of the balance sheet of a FI, differ from liquidity risk arising from the asset side of the balance sheet?
  • The asset side liquidity risk originates from the transactions that cause transferring of cash to other assets while the liquidity risk from the liability side comes from the transactions in which cash is demanded for exchange with the claim, such as withdrawing cash from a bank.
  • What are the costs and benefits to a financial institution of holding large amount of liquid assets? What concerns motivate regulators to require deposit taking institutions to hold minimum amounts of liquid assets??
  • The benefit of holding large amounts of liquid assets such as cash, is that it enables banking financial institutions to easily cater for large and mostly unexpected withdrawals such as panic withdrawals without reverting to the sale of other assets to cater for the emergency funding. Resulting to such emergency sale of assets would realize losses as they wouldn’t fetch their fair value
  •  The disadvantage of holding large amounts of liquid assets is that they generally generate lower yields. This means that such institutions will end up posting much lower profits compared to their risk taking and aggressive competitors.
  • Regulators demand deposit taking institutions to maintain a minimum amount of liquid assets so as to enable them to survive unexpected and emergency withdrawals.
  • This is also a monetary policy tool that enables the regulators to be able to influence the amount of money supply available in the economy.
  • Such minimum deposits are also used as a source of funds by the Federal bank, as they do not pay interest for such funds.

Question 5

  1. Discuss some of the conclusions from the empirical studies on the economies of scales and X-efficiencies on the banking sector?
  • According to studies, there are little economies of scale except in the case for small banks while recent studies indicate that economies of scale are only evident in with capital outlay of between $100- million to $5 billion. These studies are however not conclusive, as they are often influenced by the model of study utilized. X- Efficiencies in revenue generation as a result of adoption of technology have greatly overshadowed cost inefficiencies.
  • Explain how technological improvements can increase an FI’s interest and non-interest income. Provide appropriate examples.
  • Technology improvements assist financial institutions to increase both interest and non-interest income by increasing efficiencies in service delivery and reducing costs. Avenues where such income would be increased include;
  1. Increasing ease of access to loans through use of banking  internet applications where customers can access loans from their computers or mobile phones
  2. Increasing the adoption of technology led services such as mobile banking and internet banking( transfer of funds from one account to another, querying loan balances, bank balances etc at a fee)
  3. Advertisement of their services through their website, social media accounts etc to increase their customer base
  • What are the ways in which deposit institutions can offset the liquidity of a net deposit drain of funds? What are the operational benefits and costs of each method?
  • Offsetting the liquidity of a net deposit drain of funds may require a deposit institution to either increase its liabilities or reduce its assets. It can increase its liabilities through issuing more long term debt, issuing additional equity or federal funds. It may decrease its existing assets by utilizing its cash reserves, calling back its loans or even selling securities. Increasing liabilities has the effect of ensuring that the size of the firm remains unaffected while decreasing its liabilities reduces the size of the firm.
  • The benefit of addressing a net deposit drain is to restore the financial health of the institution. The costs involved include loss of value through sale of assets, loss of interest by recalling loans while increasing liabilities comes with high interest rates that have to be paid for the loans borrowed. This ultimately reduces the profitability of the business.

Question 6

  1. Does the interest rate risk measured in Value-at-Risk (VaR) capture the same activities of the bank, as the maturity gap or the repricing gap do? Besides interest rate risk, what other risks do VAR measures?
  • The Value at Risk is a measure of investment risks that estimates how much a portfolio or set of investments may lose in normal market conditions in a given time period. It’s mostly used to measure how much assets would be required to cover possible loss by financial institutions. While a Value at Risk captures information on possible loss, a reprising gap focuses on changes in net interest income while maturity gap ignores the cash flow timing, focusing only on changes in the value of equity.
  • Besides the interest rate risk, the Value at Risk also measures the market risk
  • One of approaches commonly used in the estimation of VaR is the back simulation. Discuss some of the shortcomings in the estimation of this approach.
  • The main shortcoming of the back simulation method is that it entails some standard error. Since the standard simulation is often conducted on historical information which may not capture the current market conditions, it produces very large standard errors and therefore the accuracy and confidence level of the results is reduced. 
  • Market changes, whether sudden or gradual may significantly alter the market conditions, making the available historical information to be stale, and not able to provide the desired results.
  • What conditions were introduced by Bank of International Settlements (BIS) to allow large banks to use internally generated models for the measurement of market risk? What types of capital can be held to meet the capital charge requirements?
  • Bank of international settlements allows large banks to utilize their internally generated market risk measurement models if such models have been approved by the regulators.
  • Such models must consider a confidence level of at least 99 percent with such VAR estimates holding for a maximum of 10 days, with the average estimate VAR being a multiple of a factor of 3
  • The minimum capital charge must be taken as the higher of the previous days VAR or the previous 60 days average.

Capital charges requirements

  1. Tier III capital that includes short term debt maturing within 2 years
  2. Tier II capital with long term subordinated maturity of over 5 years
  3. Tier I capital including shareholders equity and retained earnings.

Question 7

  1. What are the main differences between the assets, liabilities and income of an investment bank and a life insurance company? Why such differences exist?

            Assets

The assets of a life insurance company comprise mainly of longer term government and corporate bonds, equities etc, while the assets of a bank are likely to be primarily short term loans to individuals or corporations.

            Liabilities

Liabilities for a life insurance are not objectively determined, but are established using actuarial estimates as its not easy to determine when they will be paid. For investment banks, however, they can be objectively determined.

            Income

Life insurance incomes are computed on the basis of premiums received net of claims paid while investment banks make their income through interests and commissions charges for their services.

  • Discuss some reasons why in the recent decades Australian financial institutions have gradually less dependent upon retail deposits as their major source of funding.
  • Banks increasingly pay a higher price for retail funds depositors as compared to whole sale depositors therefore the move to a whole sale funding regime
  • Retails deposits are operationally expensive to maintain as many customers need to be processed, which is costly to the banks

Question 8

  1. Provide two motivations why financial institutions are prepared to expose to off-balance-sheet risk. How are the off-balance-sheet risk activities of financial institutions being monitored by the regulators?
  • By exposing to off balance sheet risk, Financial institutions are motivated by the desire to increase fees income by narrowing the spread in their borrowings
  • They are also motivated by the desire to avoid regulatory costs that would otherwise reduce their reported earnings. They are not subject to capital requirements
  • Off balance sheet activities are monitored by regulators through a requirement that they report five of their off balance sheet activities in each quarter.  These must be included under the Schedule L section of the Call report after the introduction of Basle II,
  • What moral hazard issues must a financial institution (FI) take heed of when making loan sales and securitization?
  • The moral hazard that people will assume more risks than they can possibly manage, as such loans are secured
  • That borrowers may default on loans taken
  • Why is it difficult for small banks, credit unions and building societies to measure credit risk using modern portfolio theory
  • The principle of portfolio theory is anchored on the ability of a company to diversify its investments so as to minimize or eliminate risks. Small banks, credit unions and building societies may be unable to diversify their asset base due to the limited number of clients or industries that they serve. This is even exacerbated by the fact that in most cases, their loans cannot be easily traded.

Question 9

  1. What are the two advantages of using futures contracts as a risk hedging tool?
  • The investment required to buy a futures contract is mostly small (usually about 10%) although proper prediction would mostly lead to huge profits
  • Due to the huge number of contracts that are traded in a day, it makes the trading of futures contract to lead to high liquidity.
  • Bank 1 can issue five-year CDs at a fixed rate of 11 percent or at a variable rate of LIBOR plus 2 percent. Bank 2 can issue five-year CDs at fixed rate of 13 percent fixed or at a variable rate of LIBOR plus 3 percent.
  • Discuss the potential motivation to enter into a swap transaction between the two banks
  • Based on the information above what a feasible swap?
  • Bank 1 appears to have a comparative advantage in the fixed rate investment as it has a 2 percent gain in its favor as compared to the variable rate. Bank 2, on the other hand gains more in the floating rate market as compared to the fixed rate market with -1 percent against bank 1. Comparing both banks

                                    Fixed               Variable

                                    Rate                 Rate

Bank1                          11                    L+2

Bank 2                         13                    L+3

Difference                    -2                     -1        

The net quality spread is the difference between the fixed-rate versus variable-rate differential. Thus the net quality spread = -2% – (-1%) = -1 percent. This amount represents the net amount of gains (interest savings) to be allocated between the firms

  • If a borrower intends to raise fund from the 90-day bank bill market, how can the borrower create
    a fixed rate for the length of the loan by using the forward rate agreement (FRA)?
  • By entering into a forward rate agreement with the lender, the borrower is able to lock in the interest rate for the 90-days so that they are able to borrow the funds at an agreed interest rate. This way, they will be required to pay the lender at the beginning of the forward period.
  • As a risk manager of at a medium size financial institution, what risk you potentially have exposed to if the bank wishes to liquidate some of the Treasury securities next month? How do you use option to hedge against that particular exposure?
  • The main risk would be a change in interest rate which would lead to losses when the liquidation of treasury securities happens in the coming month.
  • To hedge this risk using an option, I would buy put options that allow me to lock in the price that I would liquidate the treasury securities.

Question 10

  1. What is repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity?
  • A reprising gap measures the difference between the dollar value of assets and liabilities, both of which will reprice within a specific period of time as a result of their roll over while a rate sensitivity represents the time interval within which repricing could occur. Therefore, a change in interest rates affects interest income and interest expenses when assets and liabilities are reprised.
  • What is the duration of a bond with three years to maturity; if it has a face value of $1000 and pays 6 per cent annual coupon per annum. The current yield to maturity for bonds with similar risk and maturity are trading at 4.75% per annum.
  • What are the costs and benefits to a financial institution of holding large amount of liquid assets? Why Treasury securities are considered good examples of liquid assets?
  • The benefit of holding large amounts of liquid assets such as cash, is that it enables banking financial institutions to easily cater for large and mostly unexpected withdrawals such as panic withdrawals without reverting to the sale of other assets to cater for the emergency funding. Resulting to such emergency sale of assets would realize losses as they wouldn’t fetch their fair value
  • The disadvantage of holding large amounts of liquid assets is that they generally generate lower yields. This means that such institutions will end up posting much lower profits compared to their risk taking and aggressive competitors.
  • Treasury bills are deemed to be the good examples of liquid assets as they can easily  be converted to cash without loss of value

Question 11

  1. Discuss some of the conclusions from the empirical studies on the economies of scales and X-efficiencies on the banking sector?
  • According to studies, there are little economies of scale except in the case for small banks while recent studies indicate that economies of scale are only evident in with capital outlay of between $100- million to $5 billion. These studies are however not conclusive, as they are often influenced by the model of study utilized. X- Efficiencies in revenue generation as a result of adoption of technology have greatly overshadowed cost inefficiencies.
  • What actions have the BIS taken to protect depository institutions from insolvency due to operational risk?
  • The Basle Committee of the Bank of International Settlements proposed three methods of protecting depository institutions against insolvency. These are
  • Market discipline- ensuring accurate, timely and fair disclosure of financial information through external audits and other forms of corporate governance
  • Supervisory review- Ensuring there is adequate capital, board and senior management, risk management, internal controls capital and internal control reviews among other forms of supervisory reviews
  • Minimum capital requirements- Ensuring that depository institutions maintain the required minimum capital requirements
  • What are the ways in which deposit institutions can offset the liquidity of a net deposit drain of funds? What are the operational benefits and costs of each method?
  • Offsetting the liquidity of a net deposit drain of funds may require a deposit institution to either increase its liabilities or reduce its assets. It can increase its liabilities through issuing more long term debt, issuing additional equity or federal funds. It may decrease its existing assets by utilizing its cash reserves, calling back its loans or even selling securities. Increasing liabilities has the effect of ensuring that the size of the firm remains unaffected while decreasing its liabilities reduces the size of the firm.
  • The benefit of addressing a net deposit drain is to restore the financial health of the institution. The costs involved include loss of value through sale of assets, loss of interest by recalling loans while increasing liabilities comes with high interest rates that have to be paid for the loans borrowed. This ultimately reduces the profitability of the business.

Question 12

  1. Does the interest rate risk measured in Value-at-Risk (VaR) capture the same activities of the bank, as the maturity gap or the repricing gap do? Besides interest rate risk, what other risks do VAR measures?
  • The Value at Risk is a measure of investment risks that estimates how much a portfolio or set of investments may lose in normal market conditions in a given time period. It’s mostly used to measure how much assets would be required to cover possible loss by financial institutions. While a Value at Risk captures information on possible loss, a reprising gap focuses on changes in net interest income while maturity gap ignores the cash flow timing, focusing only on changes in the value of equity.
  • Besides the interest rate risk, the Value at Risk also measures the market risk
  • One of approaches commonly used in the estimation of VaR is the back simulation. Discuss some of the shortcomings in the estimation of this approach.
  • The main shortcoming of the back simulation method is that it entails some standard error. Since the standard simulation is often conducted on historical information which may not capture the current market conditions, it produces very large standard errors and therefore the accuracy and confidence level of the results is reduced.
  • Market changes, whether sudden or gradual may significantly alter the market conditions, making the available historical information to be stale, and not able to provide the desired results.
  • What conditions were introduced by Bank of International Settlements (BIS) to allow large banks to use internally generated models for the measurement of market risk? What types of capital can be held to meet the capital charge requirements?
  • Bank of international settlements allows large banks to utilize their internally generated market risk measurement models if such models have been approved by the regulators.
  • Such models must consider a confidence level of at least 99 percent with such VAR estimates holding for a maximum of 10 days, with the average estimate VAR being a multiple of a factor of 3
  • The minimum capital charge must be taken as the higher of the previous days VAR or the previous 60 days average.

Capital charges requirements

  • Tier III capital that includes short term debt maturing within 2 years
  • Tier II capital with long term subordinated maturity of over 5 years
  • Tier I capital including shareholders equity and retained earnings.
  • Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = 0.03X1 + 0.02X2 – 0.05X3 + error, where X1 is the borrower’s debt/equity ratio, X2 is the volatility of borrower earnings, and X3 = 0.10 is the borrower’s profit ratio. For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 = 0.10.
  • Probability of default

PD = 0.03X1 + 0.02X2 – 0.05X3 + error

PD= 0.03(0.75) + 0.02(0.25)-0.05(0.10) + Error

PD= 0.0225 + 0.005 – 0.005 + Error

PD = 0.0225 + Error

  1. List the weaknesses of this type of linear probability model?
  • It can only predict positive figure and cannot therefore be used to predict negative figures
  • It presents an inherent inaccuracy due to the presence of errors
  • It does not take into consideration the individual behavior of borrowers
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