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The interest rate tree below shows the true process for a one-year interest rate. The current one-year spot rate is 7.0%. Next year, investors expect the one-year rate to either increase to 10.0% or drop to 4.0%, with equal probability of an increase or drop. In the subsequent year (Year 2), investors similarly expect the future one-year rate to again either increase or decrease by +/- 3%, with equal likelihood. Graphically, as follows:

Before the inclusion of a risk premium, assuming the above interest rate tree the true and known process, the price of a $1,000 par two-year zero-coupon bond would be $874.13; i.e., this price is the expected discounted value under annual compounding. However, let us modify this and instead assume that investors are risk-averse: they would prefer a certain 7.0% return to an expected 7.0% return with volatility. Consequently, let us assume investors require (charge) a risk premium of 90 basis points. Compared to the risk-neutral price of $874.13, what is the change in price due to the introduction of the risk premium?

AIncrease bond price by $14.58

BIncrease bond price by $7.30

CDecrease bond price by $7.30

DDecrease bond price by $14.58

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