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Keys Corporation's 5-year bonds yield 5
Keys Corporation's 5-year bonds yield 5.10% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds?
Expert Solution
Computation of Default Risk Premium (DRP) on Keys' bonds:
r(corp) = rf + ip + Ip + drp + mrp
Here,
r(corp) = Keys Corporation's 5-year Bonds Yield = 5.10%
rf = Real Risk-free Rate = 2.5%
ip = Inflation Premium = 1.50%
lp = Liquidity Premium = 0.5%
drp = Default Risk Premium = ?
mrp = Market Risk Premium = 0.1%
Substituting the values in formula:
5.10% = 2.50% + 1.50% + 0.50% + drp + [(5-1) * 0.1%
drp = 5.10% - 2.50% -1.50% -0.50% - 0.4% = 0.20%
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