In this question we will design a loan guarantee - also known as a credit-default swap

when applied to bonds and as deposit insurance when applied to bank deposits - for

the loan in the unit trust from the first lecture. Loan guarantees, as the name suggests,

guarantee the performance of the loan and, as such, hedge default risk. Use a detailed

payoff diagram of the (i) loan without the loan guarantee, (ii) loan guarantee, and (iii)

loan with a loan guarantee for the following situations:

(a) Your parents want their loan to be risk-free.

Hint: review the construction of a

synthetic risk-free loan.

(b) Your parents want to have at least USD 50 in the event of default.

For each diagram provide a brief explanation of how the loan guarantee works.