Given a text T, and several options, according to the question posed in the text T to choose the most appropriate option from the options as the answer, please directly output the most appropriate option, do not need to output the explanation.

Lena Liecken is a senior bond analyst at Taurus Investment Management. Kristel Kreming, a junior analyst, works for Liecken in helping conduct fixed-income research for the firm's portfolio managers. Liecken and Kreming meet to discuss several bond positions held in the firm's portfolios.Bonds I and II both have a maturity of one year, an annual coupon rate of 5%, and a market price equal to par value. The risk-free rate is 3%. Historical default experiences of bonds comparable to Bonds I and II are presented in Exhibit 1.
| Exhibit 1 | Credt Rsk Information for Comparable Bonds |
| Percentage of Bonds That |
| Survive and Make Full |
| Bond | Recovery Rate | Payment |
| I | 40% | 98% |
| Ⅱ | 35% | 99% |


Bond III is a zero-coupon bond with three years to maturity. Liecken evaluates sim- ilar bonds and estimates a recovery rate of 38% and a risk-neutral default probability of 2%, assuming conditional probabilities of default. Kreming creates Exhibit 2 to compute Bond III's credit valuation adjustment. She assumes a flat yield curve at 3%, with exposure, recovery, and loss given default values expressed per 100 of par value.
| Exhibit 2Analysis of Bond III |
| LossGivenDefault | Probab ty of | Prob ablity ofSurvival | ExpectedLoss | Present Value ofExpected Loss |
| Date | Exposure | Recovery | Default |
| 0 |
| 1 | 94.2596 | 35.8186 | 58.4410 | 2.0000% | 98.0000% | 11688 | 1.1348 |
| 2 | 97.0874 | 36.8932 | 60.1942 | 1.9600% | 960400% | 1.1798 | 1.1121 |
| 3 | 100.0000 | 38.0000 | 62.0000 | 19208% | 94.1192% | 11909 | 10898 |
| Sum | 5.8808% | 3.5395 | 3.3367 |


Bond IV is an AA rated bond that matures in five years, has a coupon rate of 6%, and a modified duration of 4.2. Liecken is concerned about whether this bond will be downgraded to an A rating, but she does not expect the bond to default during the next year. Kreming constructs a partial transition matrix, which is presented in Exhibit 3, and suggests using a model to predict the rating change of Bond IV using leverage ratios, return on assets, and macroeconomic variables.
|  |
| Exhibit 3Pari alOne-Year Corporate Transition Matrix(entries in%) |

| From/To | AAA | AA | A |
| AAA | 92.00 | 6.00 | 1.00 |
| AA | 2.00 | 89.00 | 8.00 |
| A | 0.05 | 1.00 | 85.00 |
| Credit Spread(%) | 0.50 | 1.00 | 1.75 |


Kreming calculates the risk-neutral probabilities, compares them with the actual default probabilities of bonds evaluated over the past 10 years, and observes that the actual and risk-neutral probabilities differ. She makes two observations regarding the comparison of these probabilities:Observation 1: Actual default probabilities include the default risk premium associated with the uncertainty in the timing of the possible default loss.Observation 2: The observed spread over the yield on a risk-free bond in practice includes liquidity and tax considerations, in addition to credit risk.
Which of Kreming's observations regarding actual and risk-neutral default probabilities is correct?
Option A:Only Observation 1
Option B:Only Observation 2
Option C:Both Observation 1 and Observation 2

Answer: B