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(i) Why do we need to calculate the effective monthly rate…?…is it because the question gave us monthly operating cash flow and monthly volatility…?…Why can’t i do like this…14,400 x 12 – (0.08 x 1,500,000)…?
(ii) I don’t understand the logic behind the examiner’s workings…why do we need to translate the monthly volatility into two stages…?…and also how do we know that the 13% is before interest…?
(iii) The formula that the examiner used to calculate volatility after interest…what formula is that ?…i couldn’t find this formula in reference materials…
(iv) I face problems when trying to read from standard normal tables…how 0.842 standard deviation could derive at a value of 0.3…?
(v) …cumulative probability that the cash flow plus reserve will be above the default probability of 0.8…where did the 0.8 come from…?
Examiner also mentioned that the bank requires 2.16% to cover the expected loss on the loan given the probability of default. How to derive the 2.16%…?
(i) We need the monthly rate because we have monthly cash flow and monthly volatility.
With regard to arriving at it, this is Paper F2. (If for example, the monthly rate were 1%, then the yearly rate is not 12 x 1%, it is 1.01^12 – 1. Here we are doing the same thing in reverse)(ii) Operating cash flow is always before interest – it is the cash flow from operations. That is why 2 stages are needed.
(iii) You do not need a formula.
We know that the fixed interest is 67% of the operating cash flow.
So, if the cash flow was 100 then the interest would be 67, leaving a net 33.
Suppose the cash flow fell by 10% to 90. The interest would still be 67, leaving 23.
So the net amount would fall by 10 on 33, which in percentage terms is 30.3%So….the net flow changes by 30.3%/10% = 3.03 times as much as the operating cash flow. (Try any figures and you will end up with the same).
So the volatility of the net flow is 3.03 times that of the operating flow.
3.03 x 13 = 39%(iv) For 0.842 you look up 0.8 down the left hand column and 0.04 along the top. This gives 0.2995. (This is close enough for the exam – the examiner has been clever and approximated a bit further for 0.842).
You really must watch the lectures – I go through how to use the normal distribution tables.(v) The normal distribution is symmetrical. So 0.5 probability of being above or below the average.
0.5 + 0.3 = 0.8
I really would not waste too much time on this exam. It was set by the previous examiner and he set much harder questions. Your time will be better spent concentrating on the new examiner’s exams – he took over in June 2010.
(i) And also i am totally lost in part (b)…what does that equation mean…??
(ii) Examiner also mentioned that the bank requires 2.16% to cover the expected loss on the loan given the probability of default. How to derive the 2.16%…?
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