12. Suppose the rate on 1-year zero-coupon corporate bonds is 13.5% and the implied probability of default is 3.96%. Assume LGD is 100%. Based on the given information, the 1-year T-bill rate is closest to:

A. 4.49%

B. 9.00%

C. 6.74%

D. 6.00%

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A is incorrect. See the correct calculation in B below.

B is correct.

Probability of Default = 1 ? [(1 + 1-yr T-bill rate) / (1 + 1-yr corp. bond rate)] = 1 ? [(1 + 1-yr T-bill rate) / (1 + 0.135)]

Solving the above, 1-year T-bill rate = 9.005%.

C is incorrect. See the correct calculation in B above.

D is incorrect. See the correct calculation in B above.

Reference: Saunders and Cornett, Chapter 11, Credit Risk: Individual Loan Risk.