As a lender at your financial firm, you estimate that there is a 5% chance of Borrower R defaulting on a $100 million loan. Also, you estimate that there is a 2% chance of Borrower S defaulting on a similar $100 million loan. You then estimate that the recovery rate from both borrowers’ loans is 70% in the event of default (where recovery rate = RR = 1 - Loss Rate, or RR = 1 – LR). To answer these questions, you can assume that you receive interest on the portion of principal you recover from those borrowers who default on their loans, as well as interest on 100% of principal from those borrowers who do not default.) Lastly, you want a net expected return (i.e., E(Rn)) on both loans to equal the sum of your firm’s NIM and ROAA.

Net Interest Margin – 0.57% and Return on Average Assets – 0.56

a) What is the promised loan rate you would charge Borrower R? Show all work to get proper credit.

b) What is the promised loan rate you would charge Borrower S? Show all work to get proper credit.

c) If you cannot tell the difference between the credit qualities of Borrowers R and S, then what promised loan rate, if any, could you charge both in equilibrium? What type of asymmetric information problem might be present in this situation and how does this affect your answer?