Question 4

The estimated linear probability model used by a financial institution to predict business loan applicant default probabilities is given by:

PD = 0.03X1 + 0.02X2 0.05X3 + error

Where:

• X1 is the borrowers debt/equity ratio
• X2 is the volatility of borrowers earnings, and
• X3 is the borrowers profit margin

For prospective borrower A: X1 = 0.75, X2 = 0.25, and X3 = 0.15

For prospective borrower B: X1 = 0.70, X2 = 0.30, and X3 = 0.20

1. Calculate the expected probabilities of defaults (PD) for each prospective borrower and discuss how this score is used in determining the default risk classification of the prospective borrower.
2. Explain the major weakness of the linear probability model.