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1. At present, 20-year Treasury bonds are yielding 6.5% while some 20-year corporate bonds that you are interested in are yie
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Answer #1

Answer: The following are the details given  

(a) 20-year Treasury Bonds are yielding 6.5%

(b) 20-year Corporate Bonds are yielding 10.5%

(c) Liquidity Risk Premium on the Corporate Bonds is 0.50%

(d) Liquidity Risk Premium on the Treasury Bonds is 0.0%

(e) The maturity-risk premium on both bonds is the same.

(f) Treasury security should have no Default Risk Premium.

Calculation of Default Risk Premium on the Corporate Bonds

(a) 20-year Treasury Bonds are yielding 6.5% i.e. interest rate = 6.5% = Real Risk Free Interest Rate + Inflation Premium + Default Risk Premium {0%, (refer (f) above} + Maturity Risk Premium + Liquidity Risk Premium {0%, (refer (d) above}.

(b) 20-year Corporate Bonds are yielding 10.5% i.e. interest rate = 10.5% = Real Risk Free Interest Rate + Inflation Premium + Default Risk Premium + Maturity Risk Premium + Liquidity Risk Premium {0.50%, (refer (c) above}.

(c) From the above (a) & (b), it is clear that Real Risk Interest Rate, Inflation Premium and Maturity Risk Premium are same for above two bonds

(d) Therefore, Corporate Bond yield (-) Treasury Bond yield = Corporate Bond [Real Risk Free Interest Rate + Inflation Premium + Default Risk Premium + Maturity Risk Premium + Liquidity Risk Premium {0.50%, (refer (c) above}] (-) Treasury Bond [Real Risk Free Interest Rate + Inflation Premium + Default Risk Premium {0%, (refer (f) above} + Maturity Risk Premium + Liquidity Risk Premium {0%, (refer (d) above}]

(e) Therefore, Corporate Bond yield (-) Treasury Bond yield =Corporate Bond Default Risk Premium + Corporate Bond Liquidity Risk Premium {0.50%, (refer (c) above}

(f) Therefore, 10.5% - 6.5% = Corporate Bond Default Risk Premium + 0.50%

(g) Therefore, Corporate Bond Default Risk Premium = 10.5% - 6.5% - 0.50%

(h) Therefore, Corporate Bond Default Risk Premium = 3.5%

Hence, the Default Risk Premium on the Corporate Bond is 3.5%

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