Learn Before
Discrepancy Between Expected Rate of Return and Nominal Interest Rate Due to Default Risk
The expected rate of return for a lender is not always the same as the nominal interest rate charged on a loan. When there is a probability of default, the expected return is calculated by factoring in this risk, which often results in a value lower than the interest rate. For instance, a loan portfolio with a 20% nominal interest rate might only have an 8% expected return if a 10% default rate is anticipated. The lender's actual rate of return only equals the interest rate in the ideal scenario where full repayment is guaranteed.
0
1
Tags
Economics
Economy
Introduction to Macroeconomics Course
Ch.6 The financial sector: Debt, money, and financial markets - The Economy 2.0 Macroeconomics @ CORE Econ
The Economy 2.0 Macroeconomics @ CORE Econ
CORE Econ
Social Science
Empirical Science
Science
Related
Rate of Return and Loss in a Total Default Scenario
Dependence of Lender's Revenue on Rate of Return
Discrepancy Between Expected Rate of Return and Nominal Interest Rate Due to Default Risk
Relationship Between Rate of Return, Interest Rate, and Default Risk
Loan Rate of Return as a Specific Case of a General Investment Return Formula
A financial institution provides a loan of $20,000 to a client. At the end of the loan term, the client has paid back a total of $21,500. What was the financial institution's rate of return on this loan?
Comparing Loan Profitability
Calculating Required Loan Repayment
Evaluating Loan Profitability
A lender issues several loans, each with a principal of $10,000. Match each repayment scenario with the lender's resulting rate of return.
If a lender receives a total repayment that is exactly double the original amount of the loan, the rate of return on that loan is 200%.
A financial firm issues two different loans, Loan X and Loan Y, for the exact same principal amount. After one year, the total amount repaid for Loan X is greater than the total amount repaid for Loan Y. Based solely on this information, what can be concluded about the rates of return for the two loans?
A bank manager is reviewing a loan file to determine its profitability. The file shows that the borrower made a total repayment of $55,000. To accurately calculate the lender's rate of return on this loan, which single piece of information is essential?
A bank makes two separate loans. Loan A has a principal of $10,000 and is fully repaid with a single payment of $11,000. Loan B has a principal of $20,000 and is fully repaid with a single payment of $21,000. Both loans resulted in a net gain of $1,000 for the bank. Which of the following statements accurately compares the profitability of these two loans from the bank's perspective?
An investor provides a loan to a startup. At the end of the loan term, the total amount repaid by the startup is exactly 40% greater than the original amount of the loan. What is the investor's rate of return on this loan?
Learn After
A bank makes a $50,000 loan to a company at a nominal interest rate of 12%. Based on the company's financial profile, the bank estimates there is a 10% probability that the company will default and be unable to repay any of the loan. What is the bank's expected rate of return on this loan?
Loan Profitability Decision
Calculating Maximum Acceptable Default Risk
A financial institution is evaluating two potential loans of the same principal amount. Loan X offers a high nominal interest rate but is extended to a borrower with a significant probability of non-repayment. Loan Y offers a lower nominal interest rate but is extended to a borrower with a very low probability of non-repayment. Which statement provides the most accurate evaluation for the lender when deciding between these two options?
Evaluating Lender Strategy: Interest Rates vs. Risk
For a lender, the expected rate of return on a loan is always equal to the nominal interest rate charged, as long as there is no possibility of the borrower repaying the loan ahead of schedule.
A commercial bank issues a one-year loan with a stated nominal interest rate of 15%. After assessing the borrower's financial situation, the bank calculates that its expected rate of return on this loan is only 5%. Which of the following statements best explains the 10-percentage-point difference between the nominal interest rate and the expected rate of return?
Determining Required Interest Rate with Default Risk
Calculating Implied Default Probability
A lender is considering four different one-year loans, each for the same principal amount. Based on the information provided for each loan, arrange them in the correct order from the highest expected rate of return to the lowest. Assume that in the event of a default, the lender recovers none of the principal or interest.