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In evaluating credit risk, discuss the statement: "An increase in collateral is a direct substitute for an increase in default risk.

In evaluating credit risk, discuss the statement: “An increase in collateral is a direct substitute for an increase in default risk.” In your discussion, evaluate the credit risk premium on a one-year loan with and without collateral using the following formula and values: Risk Premium with collateral:

where, k = required yield on a risky loan, i = 0.05 (default risk free interest rate), p = 0.95 (the probability that the loan will be paid in full in one year), (1-p) = 0.05 (probability of default over the year), and = 0.9 (the portion of the loan collateralized for certain).

please provide calculations and explanations

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Top Answer

(1-p) = 0.1 =>p=1-.1=.9 credit risk premium on a one-year loan with collateral(γ = 0.9) = [(1+i) / (y+p - py)] - (1+i)=... View the full answer

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