If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond? Show work.
Corporate bond yield includes liquidity premium and default risk premium which is not includes in T bonds. So, in 10 year T bond and 10 year corporate bond yield, liquidity risk premium and default risk premium are extra factor.
So value of default risk premium = (10 year corporate bond yield – 10 year T bond Yield) – liquidity risk premium
= (8.50% – 6.20%) – 0.40%
= 2.30% – 0.40%
Default risk premium is 1.90%.
Option (D) is correct answer.