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The real risk-free rate, r∗, is 1.2%. Inflation is expected to average 1.1% a year for the next 4 years, after which time inflation is expected to average 3.8% a year. Assume that there is no maturity risk premium. An 11-year corporate bond has a yield of 8.5%, which includes a liquidity premium of 0.2%. What is its default risk premium? Do not round intermediate calculations. Round your answer to two decimal places. %

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Final answer:

To calculate a bond's default risk premium, subtract the real risk-free rate, average inflation rate, and liquidity premium from the bond's yield. Given the bond's yield of 8.5% and a liquidity premium of 0.2%, using a simplified constant inflation rate of 1.1%, the risk-free rate of 1.2% results in a default risk premium of 6.0%.

Step-by-step explanation:

The student is asking to calculate the default risk premium for an 11-year corporate bond with certain parameters given. To deduce the default risk premium, we must subtract the real risk-free rate, the expected inflation rate, and the liquidity premium from the corporate bond's yield. However, since inflation rates are expected to change after 4 years, we'd normally use the average inflation rate over the entire period, although this isn't directly provided in the question. But, taking the provided information into account, assuming a constant inflation rate could be viewed as a simplification for the purpose of this question. Therefore, consider the initial risk-free rate of 1.2%, and add an averaged expected inflation. Then subtract the sum from the corporate bond yield of 8.5% and also subtract the given liquidity premium of 0.2% to isolate the default risk premium.

Assuming a constant average inflation rate is used, and ignoring the change after 4 years for the sake of this example, let's calculate the default risk premium:

Bond's yield = 8.5%
Risk-free rate = 1.2%
Average inflation rate (simplified) = 1.1%
Liquidity premium = 0.2%

Default risk premium = Bond's yield - (Risk-free rate + Average inflation + Liquidity premium)

Thus, Default risk premium = 8.5% - (1.2% + 1.1% + 0.2%) = 6.0%

This is a simplified calculation approach that assumes a constant inflation rate when, in reality, the problem states that the inflation rate will change. The actual inclusion of a varying inflation rate would complicate the calculation significantly.

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