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I was trying to understand the model of credit on page 328 of Carl Walsh's Monetary Policy and Theory Book.

"Loans are, however, characterized by more than just their interest rate. For example, suppose a loan is characterized by its interest rate $r_l$, the loan amount $L$, and the collateral the lender requires is $C$. The probability that the loan will be repaid depends on the (risky) return yielded by the borrower’s project. If the project return is $R$, then the lender is repaid if, $L(1+r_l)< R+C$. If $L(1+r_l)> R+C$ , the borrower defaults and the lender receives $R+C$."

What I do not understand is that how come the return of the lender is $C+R?$ I believe it should just be $C$ (the collateral). Having $R$ in the case of default is central to the idea that the expected profit of lenders is decreasing in variance of the project outcome, which is important for the following arguments. If anybody can shed some light on this, that will be super helpful.

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    $\begingroup$ I think most of us don't have the book. If you want an answer, it would be helpful if you could edit your question and provide more information. What's the setup of the model, what is $C$, $R$, $x$, etc.? $\endgroup$ – tdm May 31 at 10:18
  • $\begingroup$ I have edited the question. Hope that helps. $\endgroup$ – Debmallya Chanda May 31 at 14:57
  • $\begingroup$ Sorry, which edition? Walsh updates his book from time to time. $\endgroup$ – Royun Jun 1 at 17:29
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If the borrower goes bankrupt, the lender has still received all of the loan payments up to that point, and the borrower's remaining assets are also distributed amongst its lenders (creditors). If there is only one lender they will get all the assets.

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