NikkiG’s Corporation’s 10-year bonds are currently yielding a return of 6.80 percent. The expected inflation premium is 1.20 percent annually and the real risk-free rate is expected to be 2.10 percent annually over the next ten years. The liquidity risk premium on NikkiG’s bonds is 0.30 percent. The maturity risk premium is 0.15 percent on 3-year securities and increases by 0.07 percent for each additional year to maturity. Calculate the default risk premium on NikkiG’s 10-year bonds. (Round your answer to 2 decimal places.)

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Asked Nov 1, 2019
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NikkiG’s Corporation’s 10-year bonds are currently yielding a return of 6.80 percent. The expected inflation premium is 1.20 percent annually and the real risk-free rate is expected to be 2.10 percent annually over the next ten years. The liquidity risk premium on NikkiG’s bonds is 0.30 percent. The maturity risk premium is 0.15 percent on 3-year securities and increases by 0.07 percent for each additional year to maturity. Calculate the default risk premium on NikkiG’s 10-year bonds. (Round your answer to 2 decimal places.)

 

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Expert Answer

Step 1

Current Yield = 6.80%

Expected Inflation Premium (EIP) = 1.20%

Risk-free Rate (RFR) = 2.10%

Liquidity Risk Premium (LRP) = 0.3%

Maturity Risk Premium (MRP) = 0.64%

 

Calculation of Default Risk Premium (DRP) for 10-year bonds:

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Current Yield - EIP - RFR - LRP -MRP DRP -6.80%-1.20%-2.10%-0.30%-0.64% 2.56%

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Step 2

Working Note:

Maturity Risk Premium for 3 years = 0.15%

Increase in Maturity Risk Premium for remaining maturity period = 0.07%

Remaining Maturity Period = 1...

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RP Maturity Ri sk Premium for 3 years +(Increa se in Maturity Risk Premium x Remaining Maturity Period 015%+ (0.07%x 7) 0.15%0.49% 0.64%

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