What is default risk premium and give it an example?

Finance Nov 13, 2020

Expert Solution

Default risk premium: The default risk premium refers to additional amount of return that the company must pay to compensate for the risk of default. The default risk premium is directly proportionate to the risk of default, If the risk is higher then the premium is higher, if the risk is lower, then the premium is lower.

The company with lower financial credibility has to offer higher yield bond as it include higher Default risk premium due to higher risk and vice-versa, The companies like S&P, Moody's issue credit rating of the bonds which helps to classify higher risk and lower risk bonds which is useful to estimate Default risk premium.

Examples: A company issues 3% for 1 year bond while it pays 4% for 2 year bonds, The difference is the default risk premium as the maturity is higher which increase the risk.

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