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1. The real risk-free rate, r*, is 2.25%. Inflation is expected to average 3.8% a year...

1. The real risk-free rate, r*, is 2.25%. Inflation is expected to average 3.8% a year for the next 3 years, after which time inflation is expected to average 4.0% a year. Assume that there is no maturity risk premium. A 7-year corporate bond has a yield of 8.88%, which includes a liquidity premium of 1.0%. What is its default risk premium?

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Answer #1

Real Risk-free Rate = 2.25%

Inflation rate for next 3 years is 3.80% and 4.00% thereafter

Inflation Premium = [3.80% + 3.80% + 3.80% + 4.00% + 4.00% + 4.00% + 4.00%] / 7
Inflation Premium = 27.40% / 7
Inflation Premium = 3.91%

Maturity Risk Premium = 0.00%
Corporate Bond Yield = 8.88%
Liquidity Premium = 1.00%

Corporate Bond Yield = Real Risk-free Rate + Inflation Premium + Maturity Risk Premium + Liquidity Premium + Default Risk Premium
8.88% = 2.25% + 3.91% + 0.00% + 1.00% + Default Risk Premium
8.88% = 7.16% + Default Risk Premium
Default Risk Premium = 1.72%

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