Question

For the next two questions, assume that risk neutral investors decide whether to invest in a risk-free bond with interest rate i0 or a government bond with default risk. With probability ω investors lose their investment in the government bond (including the interest payment). With probability 1 − ω investors receive interest rate i. Mark the correct statements.

4. The arbitrage equation of investors can be written as:

(a) (1+i)=(1−ω)(1+i0)
(b) (1+i0)=(1−ω)(1+i)
(c) ω+i0 =(1−ω)i
(d) i = i0+ω 1−ω
(e) i+ω=(1−ω)i0

Answer 1

The arbitrage equation of investors can be written as (a) (1+i)=(1−ω)(1+i0)