Bank A of Illustration 5.1 has made a risk assessment of the borrower and is confident that there is a 95 per cent probability of the borrower repaying the principal and interest as scheduled. It also makes a conservative estimate that in case of default, the bank can recover about 85 per cent of the principal and interest due. The bank feels that it cannot quote a rate lower than 14 per cent on the loan. What should be the rate it quotes to the borrower to include the default risk? Let us assume that the bank”s cost of funds is 12 per cent and the servicing costs are at 0.25 per cent.
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