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FRM Part II · FRM Exam Part II · The Rise and Risks of Private Credit

A fund of 100 loans has equal weights. Loans in the fund yield a floating base rate of 4% plus a 6% spread. The portfolio is 1.0x levered at 5% borrowing cost (equity equals assets, borrowed amount equals equity). Ignoring fees and defaults, what is the return on equity, and what is it if annual credit losses are 2% of total assets?

Return on equity is 15% before losses: assets of 2E earn 10%, giving 0.20E, less 0.05E interest. Credit losses of 2% on total assets cost 0.04E, cutting return on equity to 11%, because leverage magnifies the loss on equity.

  1. A15% without losses; 13% with losses
  2. B10% without losses; 8% with losses
  3. C15% without losses; 11% with lossesCorrect
  4. D14% without losses; 12% with losses

Explanation

Asset yield is 10%. With equity E and debt E, assets are 2E. Income is 0.10 x 2E = 0.20E, interest is 0.05E, net 0.15E, so ROE is 15%. Losses of 2% of 2E are 0.04E, giving 11%. Option one forgets that losses apply to total assets, not only equity.

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