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FRM Part II · FRM Exam Part II · The Global Drivers of Private Credit

A private credit fund has USD 400 million of equity and borrows USD 600 million from banks, investing the full USD 1,000 million in loans yielding 10% with an annual cost of debt of 6%. Ignoring fees and defaults, loan losses of what percentage of the loan portfolio would wipe out one year of equity income, and what is that equity return before losses?

Net income is 100 of interest less 36 of debt cost, which is 64 million, giving a 16% return on 400 million of equity. Loan losses of 64 million, or 6.4% of the 1,000 million portfolio, would exactly eliminate that year's equity income.

  1. AReturn 16.0% on equity; losses of 6.4% eliminate the year's incomeCorrect
  2. BReturn 16.0% on equity; losses of 6.4% eliminate the entire equity
  3. CReturn 10.0% on equity; losses of 4.0% eliminate the year's income
  4. DReturn 16.0% on equity; losses of 4.0% eliminate the year's income

Explanation

Income = 1,000 x 10% = 100; interest = 600 x 6% = 36; net = 64. Equity return = 64/400 = 16%. Losses equal to 64 are 64/1,000 = 6.4% of the portfolio, which cancels one year's income. The second option confuses income with the entire equity (which would need 40% losses).

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