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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 6.2%, 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%
Expert Solution
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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