A Treasury bond that matures in 20 years has a yield of 8%. A 20-year corporate bond has a yield of 11%. Assume that the liquidity premium on the corporate bond is 1.0%. What is the default risk premium on the corporate bond?
a. 0.50%
b. 1.75%
c. 1.00%
d. 1.50%
e. 2.00%

e. 2.00%

Explanation:

Default risk premium is the compensation that is paid to the investors for an entity's chances of defaulting on its debt.

Treasury bonds are considered to be the risk free assets.

Liquidity risk premium is the amount compensated to investors for the assets not actively traded in the market.

Treasury bonds are highly liquid form of an asset class.

In order to make a valid comparison between two securities

liquidity premium of 1% will be reduced from 11% of corporate bond. Leaving behind 10% to make both assets liquid and of valid comparison.

default risk premium = 10% return of corporate bond - 8% of Treasury bond return

Default risk premium = 2%

the answer is a.

by: nicholas dooley