Fundamentals of Financial Manageme...
Solutions
Fundamentals of Financial Manageme...
DEFAULT RISK PREMIUM A company’s 5-year bonds are yielding 7.75% per year. Treasury bonds with the same maturity arc yielding 5.2% per year, and the real risk-free rate (r*) is 2.3%. The average inflation premium is 2.5%; 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 1%, what is the default risk premium on the corporate bonds?
To identify:
The default risk premium.
Default Risk Premium:
A premium, which is paid by the borrower to its lender in the form of compensation of lender’s money in the regards of default risk is known as default risk premium.
Solution:
The items required for the calculation of default risk are corporate yield, Treasury bond yield and liquidity premium.
Given,
The corporate yield is 7.75%.
The Treasury bond yield is 5.2%.
The liquidity premium is 1%.
Formula to calculate the default risk premium derives from the formula of corporate bond yield,
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