Question

A particular security’s equilibrium rate of return is 8 percent. For all securities, the inflation risk premium is 1.95 percent and the real risk-free rate is 3.2 percent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.95 percent. The security has no special covenants. Calculate the security’s default risk premium.

Answer 1

I* =8%

IP =1.95%

RIR =3.20%

DRP =?

LRP =0.25%

MRP =0.95%

SCP =0.00%

The fair interest rate on a financial security is calculated as

i* = IP + RIR + DRP + LRP + SCP + MRP

8% = 1.95% + 3.2% + DRP + 0.25% + 0% + 0.95%

DRP = 8% - 1.95% - 3.2% - 0.25% - 0% - 0.95%

DRP = 1.65%

So, security's default risk premium is 1.65%