A customer has approached a local credit union for a $20,000 1-year loan at a 10% interest rate. If the credit union does not approve the loan application, the $20,000 will be invested in bonds that earn a 6% annual return. Without additional information, the credit union believes that there is a 5% chance that this customer will default on the loan, assuming that the loan is approved. If the customer defaults on the loan, the credit union will lose the $20,000.
What should the credit union do? What is their expected profit?
What will be an ideal response?
The tree above shows that the best alternative is not to make the loan, and to invest the funds in bonds earning 6% interest instead. The EMV of this option is $1,200.
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What will be an ideal response?
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