Principles of Money, Banking & Financial Markets 12th Edition by Lawrence Ritter,William Silber,Gregory Udell

Exercise 5

As a banker, you know that your clients have two opportunities: (1) borrow $1,000 and invest it in a safe venture that guarantees a return of $1,200 or (2) borrow $1,000 and invest it in a risky venture that returns $2,500, 20 percent of the time, $ 1.200. 50 percent of the time, or returns zero dollars, the other 30 percent of the tune. Finally, assume the market interest rate on loans is 15 percent so, at the end of one year, the borrower will incur $150 of interest payments
a. Calculate the end-of-year expected returns for your clients if they take the safe opportunity versus the risky opportunity. From the bank's perspective, which opportunity would the bank desire their customers to undertake ( Hint: Calculate the bank's expected return, assuming that the bank receives nothing if the borrower defaults.)
b. Imagine that in order for the borrower to receive the $1,000 loan from the bank, the bank places a lien on the borrowers bicycle such that if the borrower does not repay the bank, the bank can take ownership of the bicycle. If the bicycle is worth $850, will the borrower undertake the safe or the risky opportunity