Q1.2

Grading comment:

Write down an expression for the profit that a borrower expects from Project G and submit an image file depicting your answer.

Q1.3

Grading comment:

Suppose r_g =0.065rg=0.065, r_b =0.10rb=0.10, p_g =0.85pg=0.85, p_b =0.3pb=0.3, r_D =0.02rD=0.02, L=100L=100. Find the value for r_L^rL such that the borrower is indifferent between projects G and B. Round to three decimal places.

Q1.4

Grading comment:

Either by hand or using a computer, graph the lenders expected profit function E(\pi^L)E(L) for values of r_LrL between 0.00 and 0.10. Make sure axes and r_L^*rL are clearly labeled.

Upload an image file containing your graph.

Q1.5

Grading comment:

Explain in words what is happening to the borrowers behavior at the discontinuity in the lender's profit function that you graphed in the previous question.

Q1 9 Points A competitive lender makes loans to a pool of borrowers that are identical. After borrowers have received their loans they choose one of two investment projects. Project G pays the borrower a rate of return of rg with probability pg. With probability 1pg, the project earns a zero rate of return, the borrower defaults on the Ioan, and the lender receives back the initial Ioan amount. Project B pays the borrower a rate of return of rb with probability pb. With probability 1pb, the project earns a zero rate of return, the borrower defaults on the loan, and the lender receives back the initial Ioan amount. We assume that rgpb, and pg(1+rg)>pb(1+rb). The lender can't observe in which project the borrower invests and so it charges all borrowers the same interest rate rL. The lender lends an amount L and pays interest rD on funds acquired from depositors. Q1.1 1 Point Which project would the lender prefer that the borrowers undertake? Project B Project G Q1 9 Points A competitive lender makes loans to a pool of borrowers that are identical. After borrowers have received their loans they choose one of two investment projects. Project G pays the borrower a rate of return of rg with probability pg. With probability 1pg, the project earns a zero rate of return, the borrower defaults on the Ioan, and the lender receives back the initial Ioan amount. Project B pays the borrower a rate of return of rb with probability pb. With probability 1pb, the project earns a zero rate of return, the borrower defaults on the loan, and the lender receives back the initial Ioan amount. We assume that rgpb, and pg(1+rg)>pb(1+rb). The lender can't observe in which project the borrower invests and so it charges all borrowers the same interest rate rL. The lender lends an amount L and pays interest rD on funds acquired from depositors. Q1.1 1 Point Which project would the lender prefer that the borrowers undertake? Project B Project G