A bank prices retail credit loans based on median default rates. Over the long run, it can expect:

A bank prices retail credit loans based on median default rates. Over the long run, it can expect:
A . Overestimation of risk and overpricing, leading to lossof market share
B . A reduction in the rate of defaults
C . Correct pricing of risk in the retail credit portfolio
D . Underestimation and therefore underpricing of risk in it retail portfolio

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Answer: D

Explanation:

The key to pricing loans is to make sure that the prices cover expected losses. The correct measure of expected losses is the mean, and not the median. To the extent the median is different from the mean, the loans would be over or underpriced.

The loss curve for credit defaults is a distribution skewed to the right. Therefore its mode is less than its median which is less than its mean. Since the median is less than the mean, the bank is pricing in fewer losses than the mean, which means over the long run it is underestimating risk and underpricing its loans. Therefore Choice ‘d’ is the correct answer. If on the other hand for some reason the bank were overpricing risk, its loans would be more expensive than its competitors and it would lose market share. In this case however, this does not apply. Loan pricing decisions are driven by the rate of defaults, and not the other way round, therefore any pricing decisions will not reduce the rate of default.