Nikki G's Corporations 10-Year Bonds Are Currently Yielding

Nikki Gs Corporations 10 Year Bonds Are Currently Yielding A Return

Nikki G’s Corporation’s 10-year bonds are currently yielding a return of 6.35 percent. The expected inflation premium is 1.05 percent annually, and the real interest rate is expected to be 2.70 percent annually over the next ten years. The liquidity risk premium on Nikki G’s bonds is 0.55 percent. The maturity risk premium is 0.20 percent on 4-year securities and increases by 0.09 percent for each additional year to maturity. Calculate the default risk premium on Nikki G’s 10-year bonds.

Paper For Above instruction

The calculation of the default risk premium (DRP) on Nikki G’s 10-year bonds requires us to systematically analyze and subtract all other components contributing to the total yield, isolating the premium attributable specifically to default risk. Bond yields are influenced by several factors, including the real interest rate, expected inflation, liquidity risk, maturity risk, and default risk. Understanding the interplay of these components is essential in determining the default risk premium accurately.

The given data for the bond yield components are as follows:

  • Total yield: 6.35%
  • Expected inflation premium: 1.05%
  • Real interest rate: 2.70%
  • Liquidity risk premium (LRP): 0.55%
  • Maturity risk premium (MRP): to be calculated based on year to maturity (10 years)

First, it is important to understand that the nominal yield (yield to maturity) on the bond can be expressed as the sum of these components:

Nominal Yield = Real Rate + Expected Inflation + Maturity Risk Premium + Liquidity Risk Premium + Default Risk Premium

Given that, we can reorganize the formula to isolate the default risk premium:

DRP = Nominal Yield - [Real Rate + Expected Inflation + Maturity Risk Premium + Liquidity Risk Premium]

Next, we need to calculate the maturity risk premium (MRP) for the 10-year bond. The MRP on a 4-year security is 0.20%. For each additional year to maturity, the premium increases by 0.09%. Since the bond matures in 10 years, the increase in the risk premium over 4 years (from 4 to 10 years) is:

Additional years = 10 - 4 = 6 years

Additional MRP = 6 * 0.09% = 0.54%

Therefore, total MRP on the 10-year bond is:

MRP = 0.20% + 0.54% = 0.74%

Now, substitute all the known components into the formula to find the default risk premium:

DRP = 6.35% - [2.70% + 1.05% + 0.74% + 0.55%]

DRP = 6.35% - (2.70% + 1.05% + 0.74% + 0.55%)

DRP = 6.35% - 5.04%

DRP = 1.31%

Thus, the default risk premium on Nikki G’s 10-year bonds is approximately 1.31%.

Rounding to two decimal places, the final answer remains 1.31%.

References

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