Question

The real risk-free rate, r*, is 1.6%. Inflation is expected to average 1.3% a year for the next 4 years, after which time inflation is expected to average 4.2% a year. Assume that there is no maturity risk premium. A 10-year corporate bond has a yield of 8.4%, which includes a liquidity premium of 0.3%.

What is its default risk premium? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Given that,

Real risk free rate r* = 1.6%

Inflation is expected to average 1.3% a year for the next 4 years, after which time inflation is expected to average 4.2% a year

=> Average inflation over 10 year i = (4*1.3 + 6*4.2)/10 = 3.04%

Yield on a 10-year bond y = 8.4%

Liquidity risk premium LRP = 0.3%

So, default risk premium DRP = y - LRP - r* - i = 8.4 - 0.3 - 1.6 - 3.04 = 3.46%

So, default risk premium on the bond is 3.46%