1. [6pts] Given the following:

a. The yield on a five-year, risk-free Treasury-note = 5%

b. The yield on a five-year, BB-quality bond = 8%, with the 3% spread reflecting only credit risk

c. The credit spread on a five-year CDS on the 5-year, BB-quality bond of 2%

(1) [2pts] Explain how a bond investor looking for a five-year, risk-free investment could gain a 1% yield over the risk-free investment by using a CDS.

1. [2pts] Explain what an arbitrageur would do.

(3) [2pts] Comment on the impact the actions by investors and arbitrageurs would have on determining the equilibrium spread on a CDS.