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Q1. Bank ABC has a loan lent to firm DEF. The interest rate charged for this loan is 8% (5% for base rate, and 3% for risk premium). The compensating balance (b) is 5%, and there is 10% reserve requirement (RR). Assuming that firm DEF has a probability of 20% to default on this loan, and once defaulted, the recovery rate is 90%, what is the expected rate of return on this loan?

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Answer #1

E(1 + r) = P(D) + [(1 - P(D)) x RR]

= 20% + (80%)(90%) = 20% + 72% = 92%

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