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How to realise the servicing fee and cost of fund here, as one is regarded as the part of the expected return, but the cost of the fund is realised as the cost and expense rather than the revenue, thanks

RAROC = one-year income on loan/AL Example: A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge an up-front fee of 1.5 percent and a servicing fee of 50 basis points. The loan has a maturity of 8 years and a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. Assume the bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent Using the RAROC model, estimate whether the bank should make the loan? a. RAROC Fees and interest earned on loan/ Loan or capital risk We ignore up-front fees in the calculation of the loan's income. ==-7.5* $5m * (.042/1.12) = -$1,406,250 Loan risk, or AL = -DL*L*(AR/(1 R) Expected interest Servicing fees Less cost of funds = 0.12 x $5,000,000 0.0050 x $5,000,000 = 0.10 x $5,000,000 $600,000 $25,000 -$500,000 $125,000 Net interest and fee income RAROC $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of funds to the bank, the bank should not make the loan. RAROC = one-year income on loan/AL Example: A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge an up-front fee of 1.5 percent and a servicing fee of 50 basis points. The loan has a maturity of 8 years and a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. Assume the bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent Using the RAROC model, estimate whether the bank should make the loan? a. RAROC Fees and interest earned on loan/ Loan or capital risk We ignore up-front fees in the calculation of the loan's income. ==-7.5* $5m * (.042/1.12) = -$1,406,250 Loan risk, or AL = -DL*L*(AR/(1 R) Expected interest Servicing fees Less cost of funds = 0.12 x $5,000,000 0.0050 x $5,000,000 = 0.10 x $5,000,000 $600,000 $25,000 -$500,000 $125,000 Net interest and fee income RAROC $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of funds to the bank, the bank should not make the loan

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