Consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for three years. Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The risk of strategy #3 for the corporate borrower is:

Question

BlackTom AI · Accepted Answer

The prompt asks us to evaluate the risks associated with Strategy #3 from the perspective of the corporate borrower, and then to pick all applicable risks from the list.
Option a. Default risk: This is the risk that the borrower will fail to repay. While default risk is always a consideration for any financing, Strategy #3’s main distinctive risk is not the default risk inherent in the agreement itself, but rather how the financing burden might be affected by future renewal terms. In other words, the question targets risks that are specifically associated with the structure of Strategy #3, not the general risk of not repaying.
Option b. Overdraft risk: This refers to the borrower drawing more than the amount available or exceeding credit limits in a bank facility. Strategy #3 does not introduce a higher overdraft risk compared to a standard term loan; it simply involves annual renewals, so overdraft risk is not the central or defining risk of this strategy.
Option c. Repricing risk: This is the risk that the interest rate or financing terms will change at the time of renewal. Since Strategy #3 uses a one-year term with annual renewals, the borrower faces the possibility that the next renewal could carry a higher rate or tighter terms, creating uncertainty about financing costs over time. This is a classic example of repricing risk tied to a rolling, short-duration borrowing arrangement.
Option d. Credit risk: This reflects the risk that the lender may not extend credit under renewed terms, or that the borrower’s creditworthiness deteriorates by the time of renewal. With annual renewals, the borrower's weaker financial condition could lead to less favorable terms or denial of renewal, making credit risk an important consideration for this strategy from the borrower’s perspective too—indeed, the borrower's ability to obtain renewal at acceptable terms is central to Strategy #3’s risk profile.
Option e. Basis risk: This would involve a mismatch between floating-rate exposures and any hedging instrument or benchmark that doesn’t move in tandem. Strategy #3 does not inherently involve a mismatch with a hedge or a separate benchmark instrument, so basis risk is not a primary concern here unless the borrower uses hedging that could diverge from actual financing costs.

In summary, the distinctive risks for Strategy #3 (a one-year borrowing that is renewed annually) are primarily the potential for higher costs upon renewal (repricing risk) and the possibility that renewal terms depend on the borrower’s evolving creditworthiness (credit risk). The other options describe risks that are either less directly tied to the structure of annual renewals or pertain to different risk contexts that are not central to this strategy’s design.

BFC3240 - S2 2025 Mock Exam

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