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Assume the following: I want to borrow $1,000 from you. I promise to repay $1,100. However, there is 10% chance that I may go bankrupt,
Assume the following:
- I want to borrow $1,000 from you. I promise to repay $1,100.
- However, there is 10% chance that I may go bankrupt, in which case I can repay only $500.
- A government bond costing $1,000 promises a 5% interest rate.
What is the expected rate of return of my personal bond? Is it higher or lower than the expected rate of return of the government bond? Then, how much money would you lend me in exchange for my promise to pay you $1,100 if you want to break even (i.e., expect to earn the same $1,100 that you could earn in the government bond.)
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