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    Default risk premium

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    The real risk-free rate, k*, is 2.5%. Inflation is expected to average 2.8 perecent a year for the next 4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3%. Assume that the liquidity premium on the corporate bond is 0.75%. What is the default risk premium on the corporate bond?

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    Solution Preview

    (* denotes multiplication, ^ denotes power)

    k = k* + IP + LP + MRP + DRP


    k = required return on a debt security

    k* = real risk-free rate of interest= 2.5%

    IP = inflation premium= 2.80% for years 0-4 & 3.75% for years 4-8 &

    LP = liquidity ...

    Solution Summary

    Default risk premium on a corporate bond is calculated given real risk-free rate, Inflation, Liquidity premium, zero Maturity risk premium.