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Homework answers / question archive / Assume that 4-year Treasury Bonds currently have a nominal yield of 6

Assume that 4-year Treasury Bonds currently have a nominal yield of 6

Economics

Assume that 4-year Treasury Bonds currently have a nominal yield of 6.2%, and a 4-year
Corporate Bonds have a nominal yield of 8.5%. If Maturity Risk Premium (MRP) on all 4-year
contracts currently is 1.3%, and Corporate Bonds currently have additional 0.4% Liquidity Risk
Premium (LRP) (whereas Treasury Bonds do not have Liquidity Risk Premium), what is the
current Default Risk Premium (DRP) on the Corporate Bonds?

A. 2.3%

B. 1.0%

C. 1.9%

D. 4.5%

E. 4.9%

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Answer

C .

Explanation

Computation of Default Risk Premium:

For Treasury Bonds,
6.2% = Risk-free Rate + Inflation Premium + Default Risk Premium + 1.3% + 0%

Default Risk-free Rate = 0% for the Treasury Bonds,
Risk-free Rate + Inflation Premium = 6.2% - 1.3% = 4.9%

For Corporate Bonds,

8.5% = Risk-free Rate + Inflation Premium + Default Risk Premium + 1.3% + 0.4%

8.5% = 4.9% + Default Risk Premium + 1.7%

Default Risk Premium = 8.5% - 4.9% - 1.7% = 1.9%

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