The real risk-free rate, r*, is 1.75%. Inflation is expected to average 2.65% a year for the next 4 years, after which time inflation is expected to average 3.05% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 9%, which includes a liquidity premium of 0.95%. What is its default risk premium? Do not round intermediate calculations. Round your answer to two decimal places.
Nominal yield on bond = Risk free rate + Inflation premium + Maturity risk premium + Default Risk Premium + Liquidity Risk Premium
Inflation premium is the average of inflation over life of the bonds.
So for 8 year bond, Inflation premium = [(2.65% * 4) + (3.05% * 4)]/8 = 2.85%
9% = 1.75% + 2.85% + 0 + Default Risk Premium + 0.95%
Default risk premium = 3.45%
The real risk-free rate, r*, is 1.75%. Inflation is expected to average 2.65% a year for...