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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

DEFAULT RISK PREMIUM A company’s 5-year bonds are yielding 7% per year. Treasury bonds with the same maturity are yielding 5.2% per year, and the real risk-free rate (r″) is 2.75%. The average inflation premium is 2.05%; 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 0.7%, what is the default risk premium on the corporate bonds?

Summary Introduction

To identify:

The default risk premium.

Introduction:

Default Risk Premium:

A premium, which a borrower pays to the lender in the form of compensation to the lender’s money in regards of default risk is known as the default risk premium.

Explanation

The items required for the calculation of default risk are corporate yield, Treasury bond yield, and liquidity premium.

Given,

The corporate yield is 7%.

The Treasury bond yield is 5.2%.

The liquidity premium is 0.7%.

Formula to calculate the default risk premium derives from the formula of corporate bond yield,

Corporatebondyield=Treasurybondyield+LP+DRPDRP=Corporatebondyield(

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