Q1: (A) Consider the option of receiving $200,000 upfront, for which you will have to sacrifice $70,000 every year for three years. You are a present biased person. That means you prefer to sacrifice more in the future than at present. Your opportunity cost is 10%. Will you accept this option? Will your decision be different if you are not a present biased person?

Now consider the option of receiving $200,000 upfront with 50% probability or nothing otherwise, for which you will have to sacrifice $50,000 every year for three years. You are a risk averse person. Your opportunity cost is 10%. Will you accept this option? Will your decision be different if you are not a risk averse person?

Show all your calculations and explain your decisions.

(B) Explain why a callable bond has a higher yield compared to a non-callable bond issued by the same firm with all other bond characteristics the same (e.g. maturity, coupon rate, coupon frequency, seniority).