Consider the following formula for calculating the contractually promised gross return on a loan k, per dollar lent: (1 + k) = 1 + [f + (BR + m)]/ {1 - [b(1 - R)]}.Which of the following statements is true?
A)The denominator is the promised gross cash inflow to the FI per dollar.
B)The denominator reflects direct fees plus the loan interest rate consisting of both, the base lending rate and the credit risk premium.
C)The formula ignores present value aspects.
D)The FI's net benefit from requiring compensating balances must consider the benefits of holding additional non-interest bearing reserve requirements.

Question

Quizplus · Accepted Answer

DThe formula provided for calculating the contractually promised gross return on a loan, $k$, per dollar lent, does not take into account the time value of money or present value aspects, which is why statement C is correct. The formula is focused on the gross return from a single period perspective without discounting future cash flows to their present value.Statement D is also correct because the formula does not directly account for the benefits that a Financial Institution (FI) might gain from requiring compensating balances. Compensating balances are funds that a borrower must keep in a non-interest-bearing account as part of the loan agreement. While the formula includes various components of the loan's cost (like fees, base rate, and credit risk premium), it does not explicitly consider the potential benefits (such as reduced risk or increased liquidity) that compensating balances could provide to the FI. These benefits are separate from the direct financial returns calculated by the formula and would need to be considered alongside it to understand the full net benefit to the FI.

Consider the Following Formula for Calculating the Contractually Promised Gross