Question

A Treasury bond that matures in 10 years has a yield of 4%. A 10-year corporate bond has a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.3%. What is the default risk premium on the corporate bond? Round your answer to two decimal places. %

Answer 1

yield on treasury bond = rt = 4%

r = real risk-free rate

IP = inflation premium

MRP = maturity risk premium

LP = liquidity premium

DRP = default risk premium

rt = r + IP + MRP ( since for treasury bond, LP = DRP = 0)

4% = r +IP + MRP

for Corporate Bond

let yield = rc = 9%

rc = r + IP + MRP + LP + DRP = r + IP + MRP + 0.3% + DRP

9% = r + IP + MRP +  0.3% + DRP

Now we know that, ( r + IP + MRP = 4% , as we calculated above) substituting in above equation:

9% = 4% + 0.3% + DRP

DRP = 9% - 4% - 0.3% = 4.7%

thus, default risk premium = 4.7%