The 10-year bonds of Gator Corporation are yielding 8% per year. Treasury bonds with the same maturity are yielding 6.4% per year. The real risk-free rate (r*) is expected to be constant at 3%. The average inflation premium is 2.5% and the maturity risk premium takes the form: MRP = 0.1%(t-1), where t = number of years to maturity. If the liquidity premium is 0.5%, what is the default risk premium on the corporate bond? a.) 0.7%

b.) 1.10%

c.) 1.00%

d.) 0.9%

The correct option is b.) 1.10%.

Explanation:

This can be calculated using the following formula:

Default risk premium = Annual bond yield - Real risk-free rate (r*) - Average inflation premium - Maturity risk premium - Liquidity premium (1)

Where;

Annual bond yield = 8%

Real risk-free rate (r*) = 3%

Average inflation premium = 2.5%

Maturity risk premium = 0.1% * (t - 1), where t = 10

Liquidity premium = 0.5%

Substituting the values into equation (1), we have:

Default risk premium = 8% - 3% - 2.5% - (0.1% * (10 - 1)) - 0.5%

Default risk premium = 8% - 3% - 2.5% - 0.9% - 0.5%

Default risk premium = 1.10%

Therefore, the correct option is b.) 1.10%.

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