Question

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.
In addition, suppose that the default risk of the government bond is increasing in the interest rate as follows: ω = ω0 + βi.

5. Assume that ω0 = 0, β = 1 and i0 = 0. Mark the correct statements.

(a) There are multiple equilibrium interest rates i for government-bonds. (b) There are exactly two equilibrium interest rates i.
(c) There is a unique equilibrium interest rate i = 0%.
(d) There is a unique equilibrium interest rate i = 100%.
(e) There are two equilibria: i = 0 % and i = 100 %.

Answer 1

The correct statements of all statements is (e) that there are two equilibria: i = 0 % and i = 100 %.