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Practice Problem 1: A bank issues a $250 loan size and the borrower will repay the...

Practice Problem 1: A bank issues a $250 loan size and the borrower will repay the loan with probability 0.75. Find the risk premium?

Practice Problem 2: What is the loan repayment amount that the borrower in problem 1 is obligated to pay the bank?

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Answer #1

Q. 1). Solution :- Risk premium (in percent terms) = 1 - Probability of repaying loan.

= 1 - 0.75

= 0.25 i.e., 25 %

Risk premium (in absolute amount terms) = Loan size * Percent risk premium.

= 250 * 25 %

= $ 62.50

Conclusion :- Risk premium = 25 % (in amount terms, Risk premium will be $ 62.50 i.e., 25 % of loan size).

Q. 2). Solution :- Loan repayment amount = Loan size * Probability of repaying loan.

= 250 * 0.75

= $ 187.50

Conclusion :- Loan repayment amount = $ 187.50

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