Consider an economy with complete markets and a representative agent with CRRA utility and coefficient of relative risk aversion equal to 2 and subjective discount factor equal to = 1. Next period, the economy will be in one of two possible states of the world: economic boom, with probability 80%, or economic bust, with probability 20%. In the former case, the aggregate endowment is 120, while it is only 100 in the latter case. Aggregate endowment today is 100.

Question A.3 Consider now a bond with physical probability of default of 5% in case of a boom, and 30% in case of a bust. In the case of default, the recovery ratio is nil. What is the probability, as of today, that the bond will be in default next period?