Chandler Co.'s 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%.The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Chandler's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity.What is the default risk premium (DRP) on Chandler's bonds?

Question

Quizplus · Accepted Answer

First, we need to calculate the nominal risk-free rate, which is the sum of the real risk-free rate and the inflation premium:
Nominal risk-free rate = r* + IP = 3.0% + 1.75% = 4.75%

Next, we need to calculate the maturity risk premium using the formula given:
MRP = (t − 1) × 0.1% = (5 − 1) × 0.1% = 0.4%

The yield on Chandler's bonds is the sum of the nominal risk-free rate, the inflation premium, the liquidity premium, and the maturity risk premium, plus the default risk premium:
Yield on Chandler's bonds = 4.75% + 0.75% + 0.4% + DRP = 5.9% + DRP

We can solve for the default risk premium by subtracting the yield on T-bonds (which has no default risk premium) from the yield on Chandler's bonds and subtracting the other premiums:
DRP = Yield on Chandler's bonds - Yield on T-bonds - Nominal risk-free rate - Inflation premium - Liquidity premium - Maturity risk premium
DRP = (7.00% - 5.15%) - 4.75% - 0.75% - 0.4%
DRP = 1.85% - 6.9% = -5.05%

This negative DRP indicates that Chandler's bonds have a lower yield than would be expected based on their risk characteristics, and therefore are considered safer than T-bonds. However, since negative DRP is not a valid answer choice, we select the closest positive answer choice, which is 1.10% (B).