Arizona State University FIN FIN 40628 1. Suppose there are two ratings categories: A and B, along with…
1. Suppose there are two ratings categories: A and B, along with default. The ratings migration probabilities look like this for a B-rated loan:
Rating in 1 year Probability
The yield on A rated loans is 5%; the yield on B rated loans is 10%. All term structures are flat (i.e. forward rates equal spot rates). A loan in default pays off 50%.
a) You have two loans in your portfolio, both are B-rated, 3-year, 10% coupon bonds
(paid annually), each with $100 face value. Compute the possible prices of the loans next year in each ratings bucket (just before the first coupon is paid).
b) Use the actual distribution and normal distributions of your positions to compute the 1-year VAR with 95% confidence for each loan.
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