This chapter builds models to determine the ‘price’ (interest rate) a lender should charge on a loan to maximize the expected profit, taking into account both the default risk of the borrower and the relationship between response (take up) rate and the price charged. Starting with a simple two-price model, it extends the ideas to risk-based pricing, including how adverse selection and affordability of repayments can be included in the model. It investigates acceptance scoring where one determines what other non-price features should be offered as part of the loan to maximize the acceptance rate and hence the profitability of the loan. It develops a game theory model based on the Edgeworth market game, which allows for the trade-offs that lenders have between profit and market share, and that borrowers have between interest rate charged and credit limit.
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