Question 8 Consider a credit market where two types of investment project (H or L) are available to borrowers: H projects have a failure probability of 0.6 and a rate of return of 10% when they succeed and 0% otherwise, and L projects have a failure probability of 0.2 and a return of 7% when they succeed, and 0% otherwise. The rate of interest is r%, which is paid to the lender in the event a project does not fail; otherwise the return to the lender is 0%. The type of project undertaken is not observed by the lender. (a) If there are two types of firm, A, B and if they choose a project at all, type A firms always choose H projects, and B types always choose L projects. Does the expected return to the lender per project increase as r increases? Assume that there are the same number of A and B types, and that both are risk neutral, and both borrow if and only if the expected rate of return is non-negative. (10 marks) (b) If all firms are identical and risk neutral, what is likely to happen? (10 marks) Question 8 Consider a credit market where two types of investment project (H or L) are available to borrowers: H projects have a failure probability of 0.6 and a rate of return of 10% when they succeed and 0% otherwise, and L projects have a failure probability of 0.2 and a return of 7% when they succeed, and 0% otherwise. The rate of interest is r%, which is paid to the lender in the event a project does not fail; otherwise the return to the lender is 0%. The type of project undertaken is not observed by the lender. (a) If there are two types of firm, A, B and if they choose a project at all, type A firms always choose H projects, and B types always choose L projects. Does the expected return to the lender per project increase as r increases? Assume that there are the same number of A and B types, and that both are risk neutral, and both borrow if and only if the expected rate of return is non-negative. (10 marks) (b) If all firms are identical and risk neutral, what is likely to happen? (10 marks)