Calculating a Bond's Default Risk Premium: Example Problem
The real risk-free rate, r*, is 2.5%. Inflation is expected to average 2.8% a year for the next 4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3%, which includes a liquidity premium of 0.75%. What is its default risk premium?© SolutionLibrary Inc. solutionlibary.com 9836dcf9d7 https://solutionlibrary.com/business/finance/calculating-a-bonds-default-risk-premium-example-problem-7eiv
The average inflation for 8 years is IP8 = (2.8% + 2.8% + 2.8% + 2.8% + 3.75% + 3.75% + ...