Problem:

A company has a one-year bond outstanding, which provides a coupon of 8% per year payable annually. The yield on the bonds (expressed with continuous compounding) is 6.0% . Risk-free rates are 4.5% for all maturities. The recovery rate is 35%. Defaults can take place half way through each year.

Question:

a)Estimate the risk-neutral default rate for one year

b)Explain carefully the distinction between real-world and risk-neutral default probabilities. Which is higher?