A bank has decided to extend a $1 million loan to a commercial client. The bank

Question

A bank has decided to extend a $1 million loan to a commercial client. The bank has a listed prime rate of 7%. The bank has estimated that the marginal cost of raising funds is 4.75%, and their non-funds operating cost is 0.25%. The bank desires a profit margin of 2% on their loans. The bank wants a default risk premium on the loan of 1.5%. They have also estimated that the loan's term risk premium is .5%. What is the interest rate this bank will charge on this loan if they use the price leadership model?

None of the other responses are correct

9%

11%

7%

9.25%

None of the other responses are correct

9%

11%

7%

9.25%

Explanation / Answer

Under Price Leadership Model, interest rate is determined in following manner -

Interest rate = Prime rate + Default risk premium + Term risk premium

If bank use the price-leadership model then the interest rate it will charge will be as follows -

Interest rate = Prime rate + Default risk premium + Term risk premium

                  = 7% + 1.5% + 0.5%

                  = 9%

So, using price-leadership model, bank will charge 9% interest rate.

Hence, the correct answer is option (B).

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