ay pos]: A risk neutral entrepreneur borrows €25,000 from a risk neutral bank and invests it in one of two projects: a safe one and a risky one. The returns from this investment are verifiable but they are subject to some uncertainty. The table below gives the probabilities of reaching each possible returns for each project. Risky Project Safe Project while the bank gets X = €5,000 0.4 0.2 X = €40,000 0.2 0.7 The bank manager and the entrepreneur have signed a contract whereby the entrepreneur must repay R(X) when he obtains returns X. The entrepreneur is then left with a profit Contract A Contract B Contract C Contract D TE = X-R(X) πB = R(X). There is no need to subtract the €25,000 which is a sunk cost for the bank. The entrepreneur is protected by limited liability meaning that when X = €5,000 he cannot repay the loan. This means that R(€5,000) = 0. X = €50,000 0.4 0.1 Repayments are made when X = €40,000 or when X = €50,000. The two parties play a sequential game and the timing is the following First, the bank manager proposes one of four contracts which are detailed in the table below. R(€5,000) R(€40,000) €0 €30,000 €0 €29,000 €0 €0 €27,000 €26,000 R(€50,000) €30,000 €31,000 €33,000 €34,000
ay pos]: A risk neutral entrepreneur borrows €25,000 from a risk neutral bank and invests it in one of two projects: a safe one and a risky one. The returns from this investment are verifiable but they are subject to some uncertainty. The table below gives the probabilities of reaching each possible returns for each project. Risky Project Safe Project while the bank gets X = €5,000 0.4 0.2 X = €40,000 0.2 0.7 The bank manager and the entrepreneur have signed a contract whereby the entrepreneur must repay R(X) when he obtains returns X. The entrepreneur is then left with a profit Contract A Contract B Contract C Contract D TE = X-R(X) πB = R(X). There is no need to subtract the €25,000 which is a sunk cost for the bank. The entrepreneur is protected by limited liability meaning that when X = €5,000 he cannot repay the loan. This means that R(€5,000) = 0. X = €50,000 0.4 0.1 Repayments are made when X = €40,000 or when X = €50,000. The two parties play a sequential game and the timing is the following First, the bank manager proposes one of four contracts which are detailed in the table below. R(€5,000) R(€40,000) €0 €30,000 €0 €29,000 €0 €0 €27,000 €26,000 R(€50,000) €30,000 €31,000 €33,000 €34,000
Chapter7: Uncertainty
Section: Chapter Questions
Problem 7.7P
Related questions
Question
![Exee omes]: A risk neutral entrepreneur borrows €25,000 from a risk neutral
bank and invests it in one of two projects: a safe one and a risky one. The returns from
this investment are verifiable but they are subject to some uncertainty. The table below
gives the probabilities of reaching each possible returns for each project.
X = €5,000
X = €40,000
X = €50,000
Risky Project
Safe Project
0.4
0.2
0.4
0.2
0.7
0.1
The bank manager and the entrepreneur have signed a contract whereby the
entrepreneur must repay R(X) when he obtains returns X. The entrepreneur is then left
with a profit
TE = X – R(X)
while the bank gets
n® = R(X).
There is no need to subtract the €25,000 which is a sunk cost for the bank.
The entrepreneur is protected by limited liability meaning that when X = €5,000 he
cannot repay the loan. This means that R(€5,000) = 0.
Repayments are made when X = €40,000 or when X = €50,000.
%3D
The two parties play a sequential game and the timing is the following
First, the bank manager proposes one of four contracts which are detailed in the table
below.
R(€5,000) | R(€40,000) | R(€50,000)
€30,000
€29,000
Contract A
€0
€30,000
€31,000
Contract B
€0
€27,000
€26,000
Contract C
€0
€33,000
€34,000
Contract D
€0](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Feb81ebdf-f65b-407c-a8ba-acdda30231ba%2F4c3c3f13-9221-48c9-a06e-5eb8e3e4e401%2Fkr9oe3_processed.jpeg&w=3840&q=75)
Transcribed Image Text:Exee omes]: A risk neutral entrepreneur borrows €25,000 from a risk neutral
bank and invests it in one of two projects: a safe one and a risky one. The returns from
this investment are verifiable but they are subject to some uncertainty. The table below
gives the probabilities of reaching each possible returns for each project.
X = €5,000
X = €40,000
X = €50,000
Risky Project
Safe Project
0.4
0.2
0.4
0.2
0.7
0.1
The bank manager and the entrepreneur have signed a contract whereby the
entrepreneur must repay R(X) when he obtains returns X. The entrepreneur is then left
with a profit
TE = X – R(X)
while the bank gets
n® = R(X).
There is no need to subtract the €25,000 which is a sunk cost for the bank.
The entrepreneur is protected by limited liability meaning that when X = €5,000 he
cannot repay the loan. This means that R(€5,000) = 0.
Repayments are made when X = €40,000 or when X = €50,000.
%3D
The two parties play a sequential game and the timing is the following
First, the bank manager proposes one of four contracts which are detailed in the table
below.
R(€5,000) | R(€40,000) | R(€50,000)
€30,000
€29,000
Contract A
€0
€30,000
€31,000
Contract B
€0
€27,000
€26,000
Contract C
€0
€33,000
€34,000
Contract D
€0
Transcribed Image Text:S) Explain what happens when each one of these contracts is proposed
to the entrepreneur.
i.
ii.
Which contract should the bank manager offer to the entrepreneur?
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