Wells Fargo is considering making a $50 million loan to Boeing. The annual interest rate on this loan is 10%. Boeing is supposed to pay interest at the end of year 1, and interest plus principal at the end of year 2. The survival rate is 92% per year and the recovery rate is 50%. The Credit Default Swap spread is 4%. If Wells Fargo decides to make the loan, it will also purchase a CDS to hedge the credit risk. In year 1, the expected cash flow to Wells Fargo is 2.76 if the loan does not default if the loan defaults. The probability for this and the expected cash flow is 4.4 loan to default in year 2 is 0.0736

A First Course in Probability (10th Edition)
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Author:Sheldon Ross
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Chapter1: Combinatorial Analysis
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Wells Fargo is considering making a $50 million loan to Boeing. The annual interest rate on this loan is
10%. Boeing is supposed to pay interest at the end of year 1, and interest plus principal at the end of
year 2. The survival rate is 92% per year and the recovery rate is 50%. The Credit Default Swap spread
is 4%. If Wells Fargo decides to make the loan, it will also purchase a CDS to hedge the credit risk. In
year 1, the expected cash flow to Wells Fargo is 2.76
if the loan does not default
and the expected cash flow is 4.4
if the loan defaults. The probability for this
loan to default in year 2 is 0.0736
Transcribed Image Text:Wells Fargo is considering making a $50 million loan to Boeing. The annual interest rate on this loan is 10%. Boeing is supposed to pay interest at the end of year 1, and interest plus principal at the end of year 2. The survival rate is 92% per year and the recovery rate is 50%. The Credit Default Swap spread is 4%. If Wells Fargo decides to make the loan, it will also purchase a CDS to hedge the credit risk. In year 1, the expected cash flow to Wells Fargo is 2.76 if the loan does not default and the expected cash flow is 4.4 if the loan defaults. The probability for this loan to default in year 2 is 0.0736
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