September 2020 Question 4

[s1645544]

Hi, please could someone explain where my understanding is wrong for this question.

My understanding is:

The bank want an annual expected return of 10%, therefore they want to receive 10000*1.1 = 11000 from the customer.

The bank will receive 10000*(1+k)^3 if the customer does not default and nothing if the customer does default.

So my attempt was..

0.857*10000*(1+k)^3 = 11000 so k = 0.087.

Thanks in advance

 

[s1645544]

Ah I see where I went wrong, annual expected return therefore they want to receive 10000*1.1^3 = 13310