Question: Problem 1 (10 points) Consider an economy with three types of bonds. All three bonds have the same characteristics, except for the identity of the

Problem 1 (10 points) Consider an economy with three types of bonds. All three bonds have the same characteristics, except for the identity of the issuer. Bond A is issued by the U.S. treasury and pays a nominal interest rate of iA = 3%. Bond B is issued by a solid company listed in the S&P 500 index and pays a nominal interest rate iB = 5%. Bond C is issued by a small company struggling to survive amidst the effects of the Coronavirus pandemic. The market thinks bond C has a probability of default of pC = 20%.

1. Compute bond Bs risk premium, xB, and its probability of default, pB.

2. Compute bond Cs risk premium, xC, and the rate of return it offers to investors, iC.

3. You are an investor interested in maximizing the expected return of buying bonds. Which bond would you choose to buy and why?

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