Specific assignment instructions: All interest rates are annual interest rates with semi-annual compounding. All coupon rates are annual rates paid semi-annually.

Problem 1 (10 points): Assume that todays 6-month spot rate is 9% and in six months the new 6-month spot rate can be either 5% or 13% with equal probability, so that the expected 6-month spot rate six months from now is equal to 9%. Keep at least 7 decimal digits for all your calculations and answers. a) (4 points) Assume people are risk-neutral. Find the 1-year spot rate b) (4 points) If people are not risk-neutral and the 1-year spot interest rate is 9%, what is the risk-neutral probability of an up move (i.e., that the forward rate will be 13%) c) (2 points) Do you think people in part (b) are risk-averse or risk-loving?