A Treasury bond that matures in 10 years has a yield of 6%. A 10 year corporate bond has a yield of 9%. Assuming that the liquidity premium on the corporate bond is 0.5%? What is the default risk premium on the corporate bond?

Thank you,
Elena

2.5%, I am still working on how to get this answer. I just know its right cause I have the answer key in the back of the book. Hopefully this will help you to find the right equation.

Just a guess: 9 - 6 - 0.5 = 2.5%.

I'd have to guess that rehmanvohra's guess is right.

Interest starts with the so-called "risk-free" rate and then starts adding risks to it. Which risks are added depends on what it is, who it is, how long it is, etc. I don't remember all those risks and how they're done -- I just remember the basic concept.

All of those risks should be in your book. Since you only have a limited number of percents given, it stands to reason that your answer is the difference between the bond's rate and the other numbers you have.

r=r*+IP+DRP+LP+MRP
rT-10=r*+IP+DRP+LP+MRP=6%
we know that treasury bills default risk=0 means have no risk of default
we also know that
DRP=LP if DRP=0 then LP=0
so
rT-10=r*+IP+MRP=6%
yield on 10 year corporate bond
rc-10=r*+IP+DRP+LP+MRP=9%
since both bonds are for 10 year so MRP&IP are the same
the difference is that corporate bond have tendency of Default risk and LP
LP=0.5% given
rc-10=r*+IP+MRP+0.5%+DRP=9%
we know that
r*+IP+MRP=6% put in above equation
rc-10=6%+0.5%+DRP=9%
rc-10=9%-6.5%=DRP
DRP=2.5%

CORPORATE BOND = corporate bond yield - treasury bond yield
= DRP + LP

CORPORATE BOND = 9-6
CORPORATE BOND= 3

DRP+ .5=3
DRP= 2.5