Exam 7: Spot Lending and Credit Risk

Use the following information for questions National Cleaner Corp.needs a $1.5 million loan to finance a project that pays off next period.There are two projects available, A and B.You are a lending officer and know about the projects but cannot control the borrower's project choice.A will yield a payoff of $6.75 million with probability 0.6 or zero with probability 0.4.B will pay off $8 million with probability 0.5 or zero with probability 0.5.Everybody is risk neutral and the riskless interest rate is 10%.You consider designing a loan contract that involves the use of collateral However, collateral is costly and $1 of the borrower's collateral is worth only 90 cents to your bank. -Suppose a secured loan is offered.How much collateral should you ask the borrower round to the nearest decimals)?

Use the following information for questions Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort. -With a secured loan and to induce Mr.Brown to strictly choose high effort level, what should be the amount of collateral?

An important difference between loans and debt securities is

Use the following information for questions Mr.Joseph Brown would like to borrow $100 from your bank to invest in a project that will pay off one period from now.This project is risky and its payoff depends on Mr.Brown's effort in managing it.If the project is successful, it pays off $400, but if it's unsuccessful, it pays nothing.Mr.Brown can choose two levels of effort, high or low.If he chooses high effort level, he suffers a personal cost of $75, but there is no personal cost associated with choosing the low effort level.With the two effort levels, the probability that the project will succeed is 0.7 and 0.5 for the high and low effort levels, respectively.The riskless interest rate is 5%, and the use of collateral is costly since for every $1 collateral the bank values it at 90 cents.Assume that you cannot observe Mr.Brown's effort. -If an unsecured loan is offered by the bank assuming that high effort level will be chosen, what is the Nash Equilibrium for Mr.Brown and what is the net payoff associated with his choice?

The use of collateral in bank lending can