Nikki G\'s Corporation\'s 8-year bonds are currently yielding a return of 12.62

Question

Nikki G's Corporation's 8-year bonds are currently yielding a return of 12.62 percent. The expected inflation premium is 3.2 percent annually and the real interest rate is expected to be 2.7 percent annually over the next 8 years. The liquidity risk premium on Nikki G's bonds is 0.5 percent. The maturity risk premium is 0.37 percent on 3-year securities and increases by 0.85 percent for each additional year to maturity.


Required:
Calculate the default risk premium on Nikki G's 8-year bonds.

Default risk premium = ?

Explanation / Answer

r = r* + IP + DRP + LP + MRP Where r = required return on a security = 12.62 r* = real risk-free rate of interest = 2.7% IP = inflation premium = 3.2% DRP = default risk premium =?? LP = liquidity premium = 0.5% MRP = maturity risk premium = 0.37%+(8-3)*0.85% = 4.62% SO putting valus, we get DRP = r-(r* + IP + LP + MRP) ie DRP = 12.62% - (2.7%+3.2%+0.5%+4.62%) = 1.60%

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