Finance questions....

Business & Finance
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1. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 8.90%.  Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%.  What is the default risk premium on corporate bonds?  

Jul 12th, 2015

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  A T-bond yield can be seperated into the following components: r*+IP+MRP 

r* = real rate of interest 

IP= inflation premium 

MRP=Maturity risk premium 

Whereas, a corporate bond yield can be separated into: r*+IP+MRP+LRP+DRP 

The only difference being the addition of a liquidity risk premium and a default risk premium. 

Unlike a corporate bond, a treasury bond is backed by the full faith and credit of the United States government. This makes the default risk premium of holding a treasury bond equal to zero. Furthermore, treasury bonds are the most liquid securities in the bond market. This makes the liquidity risk premium for treasury bonds equal to zero. 

Now that we have covered the conceptual aspect of yields, we are able to solve the problem: 

Treasury yield: 


Corporate yield: 


From the treasury yield we know r*+IP+MRP=5.30%. We can now plug this information into the equation for corporate bond yield. 


 As we  know that LRP(default risk premium on corporate bonds) is equal to .25%, so,  just plug it in: 


Now we wiIl isolate DRP by moving terms to the other side 

DRP= 8.90%-5.30%-.25%

 DRP (default risk premium on corporate bonds )= 3.35% or 335 basis points.

Please let me know if you need any clarification. I'm always happy to answer your questions.
Jul 12th, 2015

Jul 12th, 2015
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