Question: Suppose the estimated linear probability model used by Tyler Davis (TD) Bank to predict business loan applicant default probabilities is PD = 0.03X1 + 0.02X2

Suppose the estimated linear probability model used by Tyler Davis (TD) Bank to predict business loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error, where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower earnings, and X3 is the borrowers profit ratio. For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 = 0.10.

i. What is the projected probability of default for the borrower of TD Bank?

ii. What is the projected probability of repayment if the debt/equity ratio is 2.5?

iii. What is a major weakness of the linear probability model?

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