With 20% probability, the loan will pay off $20,000; with 80% probability, the loan will pay off the full promised $40,000. Therefore, the loan’s expected payoff is 20% . $20,000 + 80% . $40,000 = $36,000. The loan’s price is $36,000/1.06 ≈ $33,962. Therefore, the promised rate of return is $40,000/$33,962 − 1 ≈

17.8%. The expected rate of return was given: 6%.