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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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DEFAULT RISK PREMIUM The real risk-free rate, r″, is 1.7%. Inflation is expected to average 15% a year for the next 4 years, after which time inflation is expected to average 4.8% a year. Assume that there is no maturity risk premium. An 11-year corporate bond has a yield of 8.7%, which includes a liquidity premium of 0.3%. What is its default risk premium?

Summary Introduction

To identify: The default risk premium.

Introduction:

Default Risk Premium:

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

Explanation

The items required for the calculation of default risk are yield, real risk-free rate, maturity risk premium, and liquidity premium.

Compute the default risk premium:

The real risk-free rate is 1.7%. (Given)

Yield is 8.7%. (Given)

The liquidity premium is 0.3%. (Given)

The inflation premium is 3.6%. (Working note)

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

r=r*+IP+MRP+DRP+LPDRP=r(r*+IP+MRP+LP)

Where,

  • r is the interest rate of treasury bills.
  • r* is the real risk-free return.
  • IP is inflation premium.
  • MRP is maturity risk premium.
  • DRP is default risk premium.
  • LP is liquidity premium.

Substitute 8.7% for r, 1.7% for r* , 3.6% for IP , and 0.3% for LP.

DRP=8.7%(1.7%+3.6%+0.3%)=8.7%5.6%=3.1%

Working note:

Compute the inflation premium

Given,

The inflation premium for 4 years is 1

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