Question

There are two types of potential borrowers in equal numbers among the population. All have projects that require an investment of $100, which must be borrowed. Type A projects yield a gross return of $130 in one year with probability .8; they fail and yield 0 with probability .2. Type B projects yield a gross rate of return of $250 with probability .4, but fail, yielding zero, with probability .6. Potential lenders require a gross return of $102 on $100 loaned. With symmetric information, who will get financing and why? Now suppose the project expected returns are private information. Lenders cannot distinguish one type from another. Will any lending occur? Why or why not? Explain in detail.

Answer 1

For the first project, the expected returns are going to be,

For the second project, the expected returns are going to be,

Since the potential lenders require a gross return of $102 on $100, the first project with a an expected return of $104 is going to get financing.

In the absence of any information on returns, the lenders would not be able to estimate the expected returns and therefore, would not be able to computed the expected returns taking into account the project risks involved. Therefore, no lending would occur in that case.