Explain the concept of a risk premium in words. This example will help you understand how a risk premium may be calculated. In each of cases (a)–(d), assume that you always have the option to keep extra money in the bank at a 10% rate of interest, with no fear of losing any of this money. For each case, calculate the minimum rate of interest and, therefore, the risk premium, at which you would lend $1,000 on the informal market.

(a) With probability 1/2 the loan will be repaid with interest, and with probability 1/2 the loan will not be repaid at all.

(b) With probability 1/2 the loan will be repaid with interest, and with probability 1/2 only the principal will be repaid.

(c) With probability 1/3, the loan will be repaid with interest, with probability 1/3 only the principal will be repaid, and with probability 1/3 the loan will not be repaid at all.

(d) Just as in case (a), except that if the loan is defaulted upon, there is probability 1/2 of recovering assets from the borrower worth $500.