Kangaroo Bank charges 1% per annum loan origination fee, and price its loans based on the

inter-bank lending rate, which is currently 4.0% per annum, plus the risk premium. The bank

classifies its potential loan clients into three groups only based on the estimated systematic

loan loss sensitivity of the client sector to the bank's aggregate loan portfolio, and charges

credit risk premium accordingly.

The bank has made one-year loans to its three big clients, firm Acacia, firm Eucalypts and

firm Wildflowers, which fall into three different credit risk groups. For one-year loans, the

credit risk premium is 3%, 5% or 7% per annum based on the borrower's credit risk group

classification. Other information about one-year loans to the three firms is given below:

Estimated probability

Firm

Loan loss B

of default

Acacia

25%

1.5

Eucalypts

5%

2.0

Wildflowers

20%

0.5

where loan loss is estimated by regressing the historical loan loss ratio of each client's

sector loan portfolio on the loan loss ratio of the bank's aggregate loan portfolio.

The bank also requires its loan clients to deposit 4.0% of the contracting loan amount in the

deposit account with the bank, which the central bank imposes a 10% reserve requirement.

1) [2 Marks] What is the credit risk premium that the bank charges for the loan made to firm

Eucalypts?

% (Give answer in %)

2) [3 Marks] What is the promised annual rate of return on the loan made to firm Eucalypts?

% (Give answer to 2 decimal places in %, e.g. if your answer is 0.11123, please key in 11.12)