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homework4 - Econ 451 Homework 4(Due March 25 1 Consider an...

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Econ 451: Homework 4 (Due March 25) 1. Consider an overlapping generations model in which the population growth rate is 4% and °at money stock is constant. Each young lender has the opportunity either to hold °at money with complete safety or to lend to a borrower who may never repay the loan. The chance of such a default is 20% . (a) What is the rate of return on °at money? (b) Suppose that the lenders are risk neutral. What will be the expected rate of return on the loan? What interest rate would a lender charge a borrower for the risky loan? (c) Suppose that the lenders are risk averse. What can you say about the level of the loan rate comparing with that of (b)? Explain. 2. Suppose there is a risky project that each dollar invested pays a high return $6 with prob- ability 20% , a medium return of $2 with probability 50% , and incurs a loss of $3 with probability 30% . A risk-free asset pays gross real rate of return of 1 : 05 : (a) What is the expected gross rate of return of the risky project?
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