Given the following table:
Type of Security Interest Rate
5-Year Treasury Note 5%
5-Year Corporate Bond (High quality) 6%
5-Year Corporate Bond (Low quality) 8%
Calculate the default risk premium (DRP) on the Corporate bonds.
To sell the corporate bonds you must pay a premium of one percent more than on treasury note for the high quality and three percent more than treasury rate for low quality.
To calculate the default risk premium (DRP) on the corporate bonds, we need to find the difference between the interest rate of the corporate bonds and the interest rate of the risk-free security, which in this case is the 5-Year Treasury Note.
The formula for DRP is: DRP = Interest Rate of Corporate Bond - Interest Rate of Risk-Free Security
In this case, the interest rates are 6% for the high-quality corporate bond and 8% for the low-quality corporate bond, while the interest rate for the risk-free security is 5%.
For the high-quality corporate bond: DRP = 6% - 5% = 1%
For the low-quality corporate bond: DRP = 8% - 5% = 3%
Therefore, the default risk premium (DRP) on the high-quality corporate bond is 1%, and the default risk premium (DRP) on the low-quality corporate bond is 3%.