Reference no: EM132964521

A lender is willing to make a loan as long as a 15% expected rate of return is received. A borrower having no wealth has access to two projects that each requires $200 of initial financing.

The bank screens the loan and predicts the following pay-offs:

PROJECT A pays $325, 40% of the time, and $175, 60% of the time.
PROJECT B pays $270, 70% of the time, and $205, 30% of the time.

Problem (a) Calculate the fair rate of interest that should be charged for project A.

Problem (b) Calculate the fair rate of interest that should be charged for project B.

Problem (c) Explain the concept of 'moral hazard' in the context of this question. (Include calculations to support your answer.)

Problem (d) What is the maximum interest rate that can be charged? (Hint: Both borrowers will participate in the loan if they can obtain at least $10 in the 'high' state.)

Problem (e) Explain how the use of venture capital can solve the problem of moral hazard. (No calculations are necessary.)

Problem (f) If the market is made up of 80% of project A's and 20% of Project B's, and no project switching occurs, will the lender obtain their 15% expected rate of return?