Question

LOAN COMMITMENTS. Chara&McAvoy Inc., can choose one of two projects: safe and risky. The safe project yields $139 with probability .95 and zero with probability .05, whereas the risky project yields $160 with probability .60 and zero with probability .40. Each project requires an investment of $100, which Chara&McAvoy must borrow. The bank can make only an unsecured loan, and cannot observe the firm’s choice of project. Everyone is risk neutral, and the risk-free rate is zero.

Now suppose the bank has made a long-term relationship with Chara&McAvoy. The firm seeks two successive $100 loans to finance projects in periods 1 and 2. The bank promises to extend credit in period 2, at interest rate i2, on the condition that Chara&McAvoy repay its loan from period 1.

d. Given that the bank commits to lending in period 2, which rate i2 does it prefer?

e. Suppose the bank in period 2 charges its preferred rate. Given i2, find the maximum interest rate in period 1 for which Chara&McAvoy prefers the safe project.

f. What is the first period rate at which the bank breaks even on the two-period contract? Explain why this breakeven rate differs from the breakeven rate in part c.

g. Does the bank still offer the contract if it expects to incur a loss on the period 2 loan? Why?

h. Assuming the loan market is competitive, what is the equilibrium rate on the period 1 loan?

i. In this model, does the resolution of the Moral Hazard depend on the reputation of the lender or of the borrower?

j. Suppose Chara&McAvoy does not believe the bank will honor its promise to make the second loan. Since one loan is better than none, can Chara&McAvoy still enter a loan commitment with the bank?

k. If Chara&McAvoy defaults on its first loan, can the firm obtain a loan in period 2 by going to a different bank?

END.

Answer 1

Expected Revenue in Safe Proj = 139*0.95 = 132.05

Expected Revenue in Risky Project = 160 * 0.6 = 96

Average of expected revenue = (132.05+96) / 2 = 114

There is a probability of default if Chara and McAvoy choose the risky project.

D) If the bank commits to lending in period 2 , bank will prefer a higher interest rate I2 as Chara and McAvoy can take up risky project in Year 2. I2 will be greater than 14 percent.

E) The maximum interest rate will be less than the preferred interest rate i2. The maximum interest rate will be less than 14 percent.

F) Need info about C part to answer this question

G) Yes , the bank can offer the loan as there is a possibility of Chara and McAvoy taking up safe project in period 1 and may be capable of paying the loan in second term even if risky project is taken in second term.

H) The equilibrium rate for period 1 = (114-100)/100 = 14 percent

I) The resolution of moral hazard depends on the both the lender and the borrower . Borrower in not taking a risky project and the lender in committing to giving a loan at interest rate I2.

J) Yes , the bank can enter a loan committment with the bank and make the payments on time to improve its reputation and seek loan with different bank if required

K) No Chara and McAvoy cannot get a loan from a different bank as their credit history can be tracked by the second bank