6-3: The Determinants of Market Interest Rates Problem 6-11 Default Risk Premium

Question

6-3: The Determinants of Market Interest Rates

Problem 6-11
Default Risk Premium

A company's 5-year bonds are yielding 7.8% per year. Treasury bonds with the same maturity are yielding 4.9% per year, and the real risk-free rate (r*) is 2.1%. The average inflation premium is 2.4%, and the maturity risk premium is estimated to be 0.1(t - 1)%, where t = number of years to maturity. If the liquidity premium is 0.55%, what is the default risk premium on the corporate bonds? Round your answer to two decimal places.

%

Explanation / Answer

Answer

Yield on Corporate Bond = Risk Free Rate + Inflation Premium + Maturity Risk Premium + Default Risk Premium + Liquidity Premium

For the treasury bonds Default Risk Premium = 0, and Liquidity Premium = 0

Yield on Treasury Bond = Risk Free Rate + Inflation Premium + Maturity Risk Premium

Risk Free Rate + Inflation Premium + Maturity Risk Premium + Default Risk Premium + Liquidity Premium = 7.8%

Risk Free Rate + Inflation Premium + Maturity Risk Premium = 4.9%

Default Risk Premium + Liquidity Premium = (7.8% -4.9%)

Default Risk Premium + 0.55% = (7.8% -4.9%)

Default Risk Premium + 0.55% = 2.9%

Default Risk Premium = 2.9% -0.55%

Default Risk Premium = 2.35%

Answer : Default Risk premium on corporate bond is 2.35%

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