A customer has approached a local credit union for a $20,000 1-year loan at a 10

Question

A customer has approached a local credit union for a $20,000 1-year loan at a 10% interest rate. If the credit union does not approve the loan application, the $20,000 will be invested in bonds that earn a 6% annual return. The credit union believes that there is a 5% chance that this customer will default on the loan, assuming that the loan is approved. If the customer defaults on the loan, the credit union will lose the $20,000.

Suppose the credit union decides to thoroughly investigate the customer's credit record, and that such an investigation would indicate with complete certainty whether the customer will default on the loan. What is the most the credit union should be willing to pay for the investigation?

Explanation / Answer

SOlution-

Expected earnings at the end of year from the customer if amount is given to him as loan = ( 20000 * 1.1 ) - 20000

= 22000 - 20000

= 2200

If amount is invested in the bonds then annual earnings in the form of interest at the end of year will be =

= 20000 * ( 1.06 - 1 )

= 1200

Thus the most the credit union should be willing to pay for the investigation = difference between the earnings above

= 2000 - 1200

= $800

Answer

TY!

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