Consider a 3-year risky zero coupon bond where the probability of default, P , is the same for each year and where the recovery rate is 0%. Assume the yield curve is flat at a rate of r and that investors are risk neutral. 1. Show that the credit spread on this bond is exactly equal to P (1 + r )/(1 P ) . (Hint: First express the price of the bond at t = 0 as a function of P and r using the backwards procedure. Next, express (1 + Y T M ) of the bond at t = 0 as a function of the bond price, which should also include P and r . Finally, apply the definition of the credit spread.) 2. Suppose the bond has positive systematic risk (i.e., CAPM > 0) and that investors are risk averse. Would you expect the credit spread to be equal, greater than, or less than the credit spread in part (1)? You dont have to mathematically prove your answer, but you should provide an intuitive explanation. 3. Suppose investors are risk neutral again but that the bond has a positive recovery rate. Would you expect the credit spread to be equal, greater than, or less than the credit spread in part (1)? You dont have to mathematically prove your answer, but you should provide an intuitive explanation. 1