If 10 year T bonds have a yield of 5.2%, 10 year corporate bonds yield 7.5%, the maturity risk premium on all 10 year bonds is 1.1%, and corporate bonds have a 0.2% liquidity premium versus a zero liquidity premium for T bonds, what is the default risk premium on the corporate bond?
a)2.1% b)5.2% c)5.4% D)7.5%
I worked it as follows:
return= r* (risk free rate) + Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Risk Premium.
7.5% - 5.2% = r*
r= 2.3+ DRP + 0.2% + 1.1%
r= DRP + 3.6%
r/3.6% = DRP
DRP = 2.083%
Is this correct?
Yes, your calculation is correct.
To find the default risk premium (DRP) on the corporate bond, you need to first calculate the risk-free rate (r*) by taking the difference between the yield on the corporate bond (7.5%) and the yield on the 10-year Treasury bond (5.2%). In this case, r* = 7.5% - 5.2% = 2.3%.
Next, you can use the formula:
r = r* + Inflation Premium + DRP + Liquidity Premium + Maturity Risk Premium
Since the question does not provide an inflation premium, we can assume it to be zero.
Substituting the values into the formula, you have:
2.3% = DRP + 0.2% + 1.1%
Simplifying the equation, you get:
DRP = 2.3% - 0.2% - 1.1%
= 2.083%
Therefore, the default risk premium on the corporate bond is approximately 2.083%.
Your calculations are correct. The default risk premium on the corporate bond is 2.083%. Therefore, the answer is (a) 2.1%.
N0
7.5% - 5.2% = r*
r= 2.3+ DRP + 0.2% + 1.1%
r= DRP + 3.6%
r/3.6% = DRP
DRP = 2.083%
DRP-r=1.3 or 1.30