I want to borrow $200 from you. You are a risk-averse individual. I promise to repay $210. However, the probability of full payment (of $210) is 95%. I will pay you only $100 with 4% probability, and I will pay you nothing with 1% probability. The quoted(promised) return on this bond is 12%. What is the time premium, the default premium, and the risk premium? The government risk-free bond has a rate of return of 5%.

Hint: In this problem the expected return = time premium + risk premium, because youre risk-averse. If you were risk-neutral like we did in class, expected return=time premium, because risk-neutral investors dont care about risk, i.e. risk premium = 0. The promised return = time premium + default premium + risk premium for risk-averse people. The time premium = government risk-free rate as in the risk-neutral case, however it is not the expected return, the expected return will also include the risk premium. In this problem, first find the price of the bond base on the promised return. Remember that the promised return that is quoted to you refers to the good state (i.e. full payment). Even though we can calculate promised payments in every state, no bank or company will quote the promised payment in case of default, nobody wants to promise default, but full payment.