   # DEFAULT RISK PREMIUM The real risk-f nee rate, r*, is 2.5%. Inflation is expected to average 2.8% a year for the next 4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3%, which includes a liquidity premium of 0.75%. What is its default risk premium? ### Fundamentals of Financial Manageme...

8th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285065137

#### Solutions

Chapter
Section ### Fundamentals of Financial Manageme...

8th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285065137
Chapter 6, Problem 13P
Textbook Problem
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## DEFAULT RISK PREMIUM The real risk-f nee rate, r*, is 2.5%. Inflation is expected to average 2.8% a year for the next 4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3%, which includes a liquidity premium of 0.75%. What is its default risk premium?

Summary Introduction

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.

### Explanation of Solution

Solution:

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

The real risk-free rate is 2.5%. (Given)

Yield is 8.3%. (Given)

The liquidity premium is 0.75%. (Given)

The inflation premium is 3.275%. (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.
• MRP is maturity risk premium.
• DRP is default risk premium.

Substitute 8.3% for r, 2.5% for r*, 3.275% for IP, and 0.75% for LP.

DRP=8.3%(2.5%+3.275%+0.75%)=8.3%6.525%=1.775%

The yield on 8 year corporate bond is 1

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