An FI has issued a one-year loan commitment of $2 million for an up-front fee of

Question

   An FI has issued a one-year loan commitment of $2 million for an up-front fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The FI’s base rate on loans is 7.5 percent and loans to this customer carry a risk premium of 2.5 percent. The FI requires a compensating balance on loans of 5 percent in the form of demand deposits. Reserve require- ments on demand deposits are 8 percent. The customer is expected to draw
down 80 percent of the commitment at the beginning of the year. a. What is the expected return on the loan without taking future values into
consideration? b. What is the expected return using future values? That is, the net fee and
interest income are evaluated at the end of the year when the loan is due. c. How is the expected return in part (b) affected if the reserve requirements
on demand deposits are zero? d. How is the expected return in part (b) affected if compensating balances
are paid a nominal interest rate of 2.5 percent? e. What is the expected return using future values, but with the compen-
sating balance placed in certificates of deposit that have an interest rate of 5.5 percent and no reserve requirements, rather than in demand deposits?

Explanation / Answer

An FI has issued a one-year loan commitment of $2 million for an up-front fee of

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