Problem
The typical value of a loan is $1,000, and the interest rate charge is 14%. When the loan is repaid in full, the profit made by the company is usually $140. Therefore, the profit arising from correctly predicting the good level for a potential borrow is $140. Incorrect predicting the bad level for a potential borrower who would have repaid the loan in full will result in a negative profit (or loss) of -$140, as the company has forgone potential interest payments. Correctly predicting the bad level for a potential borrower results in no profit as no money is loaned. Incorrectly predicting the good level for a potential borrower who goes on to default on the loan, however, result in a loan not being repaid. Based on a historical example, the expected loss, in this case, referred to as the loss given default is $700 (most borrowers will repay some of their loans before defaulting). Calculate the expected benefit/loss of each model. Interpret your result.