Assume that the probability that the Patriots will win the Superbowl is 55%. A souvenir shop outside the stadium will earn net profits of $1.5 million if the Patriots win and $1.0 million if they lose. You are the loan officer of the bank to whom the shop applied for a loan. You can assume that your bank is risk neutral and that the bank can invest in safe projects that offer an expected rate of return of 10%.
(a) What interest rate would you quote if the owner asked you for a loan for $900,000 today?
(b) What interest rate would you quote if the owner asked you for a loan for $1,000,000 today? (These questions require that you compute the amount that you would demand for repayment.)