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Credit Risk . County Bank offers one-year loans with a stated rate of 9 percent but requires a compensating balance of 10 percent. What is the true cost of this loan to the borrower? How does the cost change if the compensating balance is 15 percent? If the compensating balance is 20 percent? In each case, assume origination fees and the reserve requirement are zero. The true cost is the loan rate ÷ (1 – compensating balance rate) = 9% ÷ (1.0 – 0.1) = 10 percent. For compensating balance rates of 15 percent and 20 percent, the true cost of the loan would be 10.59 percent and 11.25 percent respectively. Note that as the compensating balance rate increases by a constant amount, the true cost of the loan increases at an increasing rate. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a 0.25 percent loan origination fee, imposes a 10 percent compensating balance requirement, and must pay a 6 percent reserve requirement to the Federal Reserve. The loans typically are repaid at maturity. If the risk premium for a given customer is 2.5 percent, what is the simple promised interest return on the loan? The simple promised interest return on the loan is BR + m = 0.09 + 0.025 = 0.115 or 11.5 percent. What is the contractually promised gross return on the loan per dollar lent? Suppose the estimated linear probability model is PD = 0.3X1 + 0.2X2 - .05X3 + error, where X1 = 0.75 is the borrowers debt/equity ratio; X2 = 0.25 is the volatility of borrower earnings; and X3 = 0.10 is the borrower’s profit ratio. a. What is the projected probability of default for the borrower? PD = 0.3(.75) + 0.2(.25) - 0.05(.10) = 0.27 b. What is the projected probability of repayment if the debt/equity ratio is 2.5? PD = 0.3(2.5) + 0.2(.25) - 0.05(.10) = 0.795 The expected probability of repayment is 1  0.795 = 0.205. c. What is a major weakness of the linear probability model? A major weakness of this model is that the estim