Question
Suppose Brown Bakery needs a $1000 loan to finance a project that will pay off next year. Brown can choose between two projects. S (safe)
Suppose Brown Bakery needs a $1000 loan to finance a project that will pay off next year. Brown can choose between two projects. S (safe) and R (risky): S will yield a payoff of $2000 with probability 0.9 and nothing with probability 0.1 R will yield a payoff of $3000 with probability 0.5 and nothing with probability 0.5 Everybody is risk neutral and the riskless rate is 5%. Assume that Brown owns collateral and that collateral worth $1 to Brown is worth 0.9 to the bank. How should the bank, which operates in a competitive market, design its loan contract so that Brown will choose the safer project?
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