Explain the differences between zero exposure, ongoing exposure and time-varying exposure to default risk. (2 marks) b. Suppose that the spread between the yield on a three-year default-free zero-coupon bond and threeyear defaultable zero-coupon bond issued by a bank is 350 basis points. The Black-Scholes-Merton price of an option is $6.50. i. How much should you be prepared to pay for it if you buy it from a bank? (1 mark) ii. Assume the option can only default at maturity, and the recovery rate is 30%, what is the riskneutral probability of default? (1 mark) c. A bank enters into a credit derivative where it agrees to pay $100 at the end of one year if a certain companys credit rating falls from A to Baa or lower during the year. If the objective default probability estimated based on historical data are used to value the credit derivative, is it likely to overstate or understate the value of the derivative? Explain. (2 marks)