Assume that there are two factors influencing the past default behaviour of borrowers, these being the debt to equity ratio and the sales to assets ratio.Based on past default (repayment) experience, the linear probability model is estimated as Z_i = 0.3(D/E_i) + 0.15 (S/A_i).Assume that a prospective borrower has a D/E ratio of 0.9 and a sales to assets ratio of 2.5.What is the borrower's probability of default?

Question

Quizplus · Accepted Answer

Plugging in the given values:
Z = 0.3(0.9) + 0.15(2.5) = 0.405
The probability of default is given by the estimated value of Z, which is 0.405 or 40.5%. However, since it is a linear probability model, the maximum probability of default is 1 or 100%. Therefore, the probability of default is 0.645 or 64.5%, which is the closest option is B, 0.645.

Assume That There Are Two Factors Influencing the Past Default