1. You work for a bank that wants to earn a defaultadjusted return of 3% on unsecured 1year IO loans offered to a pool for borrowers and has asked you to determine what interest rate they should charge. (Ignore inflation and prepayment risk).

a. What interest rate should you charge if you expect 5% of borrowers will default?

b. Under what circumstances would you advise the bank not to offer any loans?

2. What is Your Anticipated Yield on the following $100,000 3year IO Mortgage Loan?

a. Annual payments and compounded interest rate of 10%

b. 12% of at risk borrowers default at the end of each year c. Loss Severity of 20% (including interest owed) when default.