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a corporations 10 years bond are currently yielding a return of 7.75 percent. the expected inflation...

a corporations 10 years bond are currently yielding a return of 7.75 percent. the expected inflation premium is 3.0 percent annually and the real interest rate is expected to be 3.00 percent annually over the next 10 years. the liquidity risk premium on the corporation's bond is 0.50 percent. the maturity risk premium is 0.25 percent on two year securities and increase by 0.10 percent for each additional year to maturity. what is the default risk premium on the corporation's 10 year bonds?

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Answer #1
Solution:
The default risk premium on the corporate bond = 0.20%
Working Notes:
Corporate bond yield = r = 7.75%
Inflation premium (IP)= 3.0%
Real interest rate = 3%
Default risk premium = DRP = ??
maturity risk premium (MRP) = MRP for 2 years securities + MRP for balance period 8 years out of 10 Years
maturity risk premium (MRP) = 0.25% +(0.10 % x (10 - 2))=0.25% + (0.10% x 8) = 0.25% +0.80% =1.05%
Liquidity risk premium = LP is included in corporate only = 0.50%
Corporate bond yield (r) = rf + IP + MRP + DRP + LP
7.75% = 3.0% + 3.0% + 1.05% + DRP + 0.50%
DRP = 7.75% - 7.55%
DRP = 0.20%
Default risk premium (DRP) = 0.20%
Please feel free to ask if anything about above solution in comment section of the question.
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