A corporation's 10-year bonds have an equilibrium rate of return of 7 percent. For all securities, the inflation risk premium is 1.50 percent and the real interest rate is 3.0 percent. The security's liquidity risk premium is 0.15 percent and maturity risk premium is 0.70 percent. The security has no special covenants. What is the bond's default risk premium?
To calculate the bond's default risk premium, we need to subtract all the other components of the bond's yield from its equilibrium rate of return.
The components we need to subtract are:
1. Inflation risk premium: 1.50%
2. Real interest rate: 3.0%
3. Liquidity risk premium: 0.15%
4. Maturity risk premium: 0.70%
Adding all these components together, we get a total of 5.35% (1.50% + 3.0% + 0.15% + 0.70% = 5.35%).
Now, subtracting the total from the equilibrium rate of return of 7.0%, we can calculate the bond's default risk premium:
Default risk premium = Equilibrium rate of return - Total other components
Default risk premium = 7.0% - 5.35%
Default risk premium = 1.65%
Therefore, the bond's default risk premium is 1.65%.