Nikki G\'s Corporation\'s 10-year bonds are currently yielding a return of 11.97
ID: 2666770 • Letter: N
Question
Nikki G's Corporation's 10-year bonds are currently yielding a return of 11.97 percent. The expected inflation premium is 3.1 percent annually and the real interest rate is expected to be 3 percent annually over the next 10 years. The liquidity risk premium on Nikki G's bonds is 1.8 percent. The maturity risk premium is 0.42 percent on 3-year securities and increases by 0.15 percent for each additional year to maturity.Required:
Calculate the default risk premium on Nikki G's 10-year bonds. (Round your answer to 2 decimal places. Omit the "%" sign in your response.)
Default risk premium %
Explanation / Answer
From the interest rates
Quoted interest rate (r) = r* + IP + DRP + LP + MRP
Here
r= rate of interest on a given security
r*= real risk-free rate of interest
IP=inflation premium
DRP= default risk premium
LP = liquidity premium
MRP= maturity risk premium
From the give data
r= 11.97 percent
r*=3 percent
IP= 3.1 percent
DRP = ?
LP= 1.8percent
MRP = 0.43 (for three years) + 0.15*7
Because MRP will 0.15 percent for each additional year maturity.
Therefore,
MRP = 0.43 +1.05
=1.48 percent
By substituting all the information in the equation we can get the DRP
11.97 = 3 + 3.1 + DRP +1.8 +1.48
DRP = 11.97 – 9.38
= 2.59 percent
Default risk premium = 2.59%
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