In evaluating credit risk, discuss the statement: An increase in collateral is a direct substitute for an increase in default risk. In your discussion, evaluate the credit risk premium on a one-year loan with and without collateral using the following formula and values: Risk Premium with collateral:

where, k = required yield on a risky loan, i = 0.05 (default risk free interest rate), p = 0.95 (the probability that the loan will be paid in full in one year), (1-p) = 0.05 (probability of default over the year), and = 0.9 (the portion of the loan collateralized for certain).