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Exam Bank

Mathematics in the Financial Industry

"We use probability a lot when deciding whether or not to offer someone a loan. For example, say a family walks in here asking for $200,000 to buy a house. We run the credit check and find that there are three possible outcomes: a 5% chance we never see them again and lose the 200 grand, a 60% chance that they pay it back and we make $50,000 in interest, and a 35% chance that we have to foreclose on the house and get our money back but don't get any interest.

"You might think it's a bad idea to gamble $200,000 to make $50,000. But let's calculate the expected value of this transaction by multiplying the probability of each outcome by the amount of money we stand to gain or lose if it happens. 0.05 times negative $200,000 is negative $10,000, and 0.6 times positive $50,000 is positive $30,000. The benefit outweighs the risk, so it makes sense to give the family a loan.

"Does that make sense? Is any of this helping you study for your exam?"

You say yes, thank you and hurry out of the bank; it didn't seem like that bank manager liked you very much.

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