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Alpha Bank determined that Delta Industrial Machinery Corporation has 2% change of default on a one-year no-payment of USD $1 million, including interest and principal repayment. The bank charges 3% interest rate spread to firms in the machinery industry, and the risk-free interest rate is 6%. Alpha Bank receives both interest and principal payments once at the end the year. Delta can only default at the end of the year. If Delta defaults, the bank expects to lose 50% of its promised payment. What may happen to the Delta's initial credit parameter and the value of its loan if the machinery industry experiences adverse structural changes?
Correct Answer: C
* Probability of Default (PD) Increase: If the machinery industry experiences adverse structural changes, the economic conditions worsen for Delta Industrial Machinery Corporation. This results in a higher likelihood of financial distress and potential default. Therefore, the probability of default increases. * Loss Given Default (LGD) Increase: In the event of adverse structural changes, the recovery rates on the loan may diminish due to potential decreases in the value of the company's assets. Hence, the bank might face higher losses if Delta defaults, leading to an increase in the loss given default. * Duration and Loan Value: An increase in both PD and LGD generally signifies greater risk. To compensate for this increased risk, the loan might be extended or restructured, leading to a longer duration. Higher risk and longer duration typically decrease the present value of the loan, as the expected cash flows are discounted more heavily due to the increased risk.