Question
Leonardo, a senior executive at the Las Vegas Home Bank, either offers only low-risk prime mortgages or a combination of prime and riskier subprime mortgages.
Leonardo, a senior executive at the Las Vegas Home Bank, either offers only low-risk prime mortgages or a combination of prime and riskier subprime mortgages. If he provides only prime mortgages, the bank's profit is $320 million with certainty. If he sell both prime and subprime mortgages, the bank earns $1 comma 600 million with a 25 % probability or minus $640 million with a 75 % probability, because subprime loans carry a high risk of default. Before, Leonardo received 1 % of the bank's profit if it was positive and nothing (but got to keep his job) if it was negative. Under his new contract, Leonardo receives a salary of $2.4 million a year and 0.25 % of the bank's profit. If the bank suffers a loss, Leonardo is fired, so that he loses his salary and receives no bonus. Assume Leonardo is risk neutral. Show that shareholders' expected earnings are higher with the new compensation scheme than with the original one. With the original compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are $___________million.(Enter your response as a whole number and include a minus sign if necessary.) With the new compensation scheme, shareholders' expected earnings (the bank's profit before paying Leonardo's salary) are $_______ million. (Enter your response as a whole number and include a minus sign if necessary.)
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