UNIT 5 AAE 130: Analyzing the Lending Operations of Selected Financial Institutions

Depository institutions

banks, savings and loan associations, mutual savings banks, credit unions

Contractual savings institutions

insurance companies and pension funds

Investment intermediaries

finance companies, mutual funds, money market mutual funds, and investment banks

Capacity

Character

Capital

Collateral

Conditions

Five C’s

Capacity

ability of the credit applicant to repay the loan when it comes due. It can be measured by looking into the financial records of

the applicant.

Character

overall impression from applicant’s credit history, business track record (if the loan purpose is for business use), past dealings with

other lending institutions, cases against individuals, etc.

Capital

the applicant must not be highly-leveraged (or has very high

amount of outstanding debts) since this will likely result to loan

default.

Collateral

these are properties pledged to the lending institution to

serve as additional protection in case of default.

Conditions

lending institutions must also consider the different

external factors which may have significant impacts on its operations

Credit scoring

normally used for smaller accounts such as

those granted to individual clients. computed using a quantitative model with

explanatory variables that are based on the credit risk of the

borrower.

information asymmetry

situation where one party has more or better information than the other.

adverse selection

market situation where asymmetric information results in a party taking advantage of undisclosed information to benefit more from a contract or trade. occurs before a transaction takes place

moral hazard

occurs when one party, who won't bear the consequences of their actions, engages in reckless behavior that could affect another party. occurs after a transaction takes place

Time Value of Money

Full amount

principal + interest

Interest

is a measure of money’s

value over time.

Interest rates

“prices paid for the use of money for a period of

time and are expressed as a percentage of the total outstanding

balance that is either fixed or variable.”

Nominal interest rates

refer to the quoted or stated rates before

taking the compounding process and inflation into account.

Real interest rates

interest rates adjusted for the expected erosion

of purchasing power resulting from inflation

Effective interest rates

rates by which the effects of compounding

over time are taken into account.

interest on principal per unt time/ principal

r

prt

Simple interest formula

Simple interest

usually is restricted to business transactions where the time involved is at

most one year. may be involved with periodic payments at

short intervals, in the discharge of debts extending over more than one

year.

COMPOUND INTEREST

If during the term of investment, the interest due at stated intervals is

added to the principal and thereafter earns interest, the sum of the

increases over the principal by the end of the term of investment is

called ________. principal increasing over time. The interest is paid more than once

during a term.

Results in higher payments.

FV= PV(1+i)^n

FV=PV(1+j/m)^mt

Final compound amount to which p accumulates by the end of n period

DISCOUNTING

Process of finding the present value of a future amount. It is done because a sum to be received in the future is worth less

than the same amount today.

P=FV(1+i)^-n

P=FV(1+j/m)^-mt

Discount formula

PRESENT VALUE OF AN ANNUITY (PVA)

The sum of the present values of all the payments of the annuity.The value of the annuity at the beginning of its term.

PVA formula

PVA = R((1-(1+j/m)^-mt)/(j/m))

FUTURE VALUE OF AN ANNUITY

The sum of all the periodic payments at the end of the term.

• The value of the annuity at the end of its term.

• “Accumulation” of the annuity

FVA Formula

FVA=R((1+(j/m)^mt)-1)/(j/m)

NOMINAL RATE (j)

The rate percent quoted/stated by the lender to the borrower, or in the other

sense the actual monetary price that borrowers pay to lenders for the use of

borrowed capital.

EFFECTIVE RATE

It takes into account the effect of compounding. rate which, if compounded annually,

is equivalent to the given rate (j).

Effective rate formula

W=interest earned in one yr/principal invested at the beginning of the year

W=(1+(j/m)^m - 1

Nominal rate formula

((w+1)^(1/m)-1)(m)