Question

Chandler Co.'s 5-year bonds yield 11.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Chandler's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Chandler's bonds?

Answer #1

Maturity Risk Premium (MRP) = (t - 1) * 0.1%

Maturity Risk Premium (MRP) = (5 - 1) * 0.1%

Maturity Risk Premium (MRP) = 0.4%

Both T-bond & Chandler Co have bonds with the same maturity

T-bonds yield = Real risk free rate + Inflation premium + Maturity Risk Premium

T-bonds yield = 3% + 1.75% + 0.4%

T-bonds yield = 5.15%

Chandler Co.'s 5-year bonds yield = Real risk free rate + Inflation premium + Maturity Risk Premium + Default risk premium + Liquidity premium

11% = 3% + 1.75% + 0.4% + Default risk premium + 0.75%

Default risk premium = 11% - 3% - 1.75% - 0.4% - 0.75%

**Default risk premium = 5.1%**

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