1.Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X 1 + .02X 2 − .05X 3

+ error, where X 1 is the borrower’s debt/equity ratio, X 2 is the volatility of borrower earnings, and X3 = 0.10 is the borrower’s profit ratio. For a particular loan applicant, X 1 = 0.75, X 2 = 0.25 and X 3 = 0.10.

What is the projected probability of repayment for the borrower?

What is the projected probability of repayment if the debt/equity ratio is 2.5?

What is a major weakness of the linear probability model? LO 10.9