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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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

Solution:

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 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.
  • IP is inflation premium.
  • MRP is maturity risk premium.
  • DRP is default risk premium.
  • LP is liquidity 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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