Keys Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.00%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Keys' 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) $\times$ 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds?

Question

Quizplus · Accepted Answer

To find the default risk premium (DRP), we need to use the formula:

YTM = r* + IP + MRP + DRP + LP

Rearranging the formula, we get:

DRP = YTM - r* - IP - MRP - LP

Plugging in the given values, we get:

7.00% = 3.00% + 1.75% + MRP + DRP + 0.75%

MRP = (5-1) * 0.1% = 0.4%

Solving for DRP, we get:

DRP = 7.00% - 3.00% - 1.75% - 0.4% - 0.75% =1.10%

Therefore, the default risk premium on Keys' bonds is 1.10%.

Keys Corporation's 5-Year Bonds Yield 7 ×\times× 01%, Where T = Number of Years to Maturity

Keys Corporation's 5-Year Bonds Yield 7 $\times$ 01%, Where T = Number of Years to Maturity