To determine the risk premium, we first calculate the credit spread. The yield difference between the corporate bond and the government bond gives the credit spread: Corporate bond yield = 6% Government bond yield =
2%
Credit spread = Corporate bond yield - Government bond yield Credit spread = 6% - 2% = 4%.
Next, we account for the expected loss. The expected loss is the probability of default times the loss given default: Probability of default = 2.5% Loss given default = 60% Expected loss = 0.025 * 0.60 = 0.015 or 1.5%.
Risk premium = Credit spread - Expected loss Risk premium = 4% - 1.5% = 2.5%.
Therefore, the risk premium included in the credit spread is 2.5%.