Question

A company's 5-year bonds are yielding 9.3% per year. Treasury bonds with the same maturity are yielding 4.65% per year, and the real risk-free rate (r*) is 2.25%. The average inflation premium is 2.00%, and the maturity risk premium is estimated to be 0.1 x (t - 1)%, where t = number of years to maturity. If the liquidity premium is 1.45%, what is the default risk premium on the corporate bonds? Round your answer to two decimal places.

Answer #1

We can calculate the desired result as follows:

Interest rate = real risk-free rate + inflation premium + maturity risk premium + liquidity premium + default risk premium

Default risk premium = Interest rate - (real risk-free rate + inflation premium + maturity risk premium + liquidity premium)

Interest rate on bonds = 9.30%

Real risk-free rate = 2.25%

Inflation premium = 2.00%

Maturity risk premium = 0.1 * (t - 1)%

= 0.1 * ( 5 - 1)

= 0.40%

Liquidity premium = 1.45%

Default risk premium = 9.30 - ( 2.25 + 2.00 + 0.40 + 1.45 )

= 9.30 - 6.10

= **3.20%**

Default risk premium comes out to be **3.20%**

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