NikkiG’s Corporation’s 10-year bonds are currently yielding a return of 6.75 per

Question

NikkiG’s Corporation’s 10-year bonds are currently yielding a return of 6.75 percent. The expected inflation premium is 1.15 percent annually and the real risk-free rate is expected to be 2.50 percent annually over the next ten years. The liquidity risk premium on NikkiG’s bonds is 0.25 percent. The maturity risk premium is 0.10 percent on 4-year securities and increases by 0.06 percent for each additional year to maturity. Calculate the default risk premium on NikkiG’s 10-year bonds.

NikkiG’s Corporation’s 10-year bonds are currently yielding a return of 6.75 percent. The expected inflation premium is 1.15 percent annually and the real risk-free rate is expected to be 2.50 percent annually over the next ten years. The liquidity risk premium on NikkiG’s bonds is 0.25 percent. The maturity risk premium is 0.10 percent on 4-year securities and increases by 0.06 percent for each additional year to maturity. Calculate the default risk premium on NikkiG’s 10-year bonds.

Explanation / Answer

Risk-free rate   rf         =          2.50%

Inflation premium IP    =          1.15%

Market rate      r          =          6.75%

Maturity                       =          10 years

Liquidity Premium LP =         0.25%

Market risk Premium MRP   =   0.10% on 4-year bonds and increases by 0.06% for additional years

                                            = 0.10% + 0.06%*6 = 0.46%

Default risk premium DRP      =          ?

r           =         rf + IP + DRP + LP + MRP

6.75% = 2.50% + 1.15% + DRP + 0.25% + 0.46%

DRP     =          6.75% - (2.50% + 1.15% + 0.25% + 0.46%)

            =          6.75% - 4.36%                        =         2.39%

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