A risk-free investment of $50,000 offers an annual return of 6%. A risky investment of $50,000 has a 40% probability of default, in which case it will pay only $25,000.
-Refer to the information above. What default premium must the risky investment offer?
A)43.3%
B)33.3%
C)37.3%
D)52.0%

Question

Quizplus · Accepted Answer

The expected return of the risky investment must equal the risk-free return plus the default premium. The expected return of the risky investment is 0.6 * $50,000 + 0.4 * $25,000 = $40,000. The risk-free return is $50,000 * 1.06 = $53,000. The default premium is ($53,000 - $40,000) / $35,000 = 37.3%.

A Risk-Free Investment of $50,000 Offers an Annual Return of 6