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6-11 A company's 5-year bonds are yielding 8.05% per year. Treasury bonds with the same maturity...

6-11

A company's 5-year bonds are yielding 8.05% per year. Treasury bonds with the same maturity are yielding 6.2% per year, and the real risk-free rate (r*) is 2.45%. The average inflation premium is 3.35%, 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 1.2%, what is the default risk premium on the corporate bonds? Round your answer to two decimal places.

= _______ %

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Answer #1

For a corporate bond,

Nominal Yield on bond Real risk free rate Inflation premium + Maturity risk premium Liquidity premium Default risk premium

For a Treasury Security, Nominal Yield Real risk free rate Inflation Premium Maturity Risk Premium where Inflation premium is

Based on the above two equations,

Nominal yield on Corporate bond = Nominal yield on Treasury security + Default risk premium + Liquidity premium

8.05% = 6.2% + DRP + 0.1(5-1)%

8.05% = 6.2% + DRP + 0.4%

DRP = 1.45%

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