Default Risk Premium Definition
The default risk premium is an additional amount of interest rates paid by a borrower to lender/ investor as a compensation for the higher credit risk of the borrower assuming his failure to pay back the principal amount in future and can be mathematically described as the difference in between the interest rates payable on bond and risk free rate of return.
Default risk premium (DRP) works as compensatory payment to investors or lenders if, in any case, borrower defaults on their debt. DRP is commonly applicable in the case of bonds. Any lender will charge a higher premium if there are chances that the borrower will default in meeting out its debt servicing, i.e., defaults in either recurring interest payments or principal amount as per the agreed terms and conditions. This acts as an incentive for the lender as he gets rewarded more for the risk undertaken.
If the lender assumes that the borrower can default in complying with its debt servicing terms and conditions, i.e., risk of non-payment, the lender may charge a higher DRP. Investors who have poor credit records pay a greater interest rate to borrow money. If adequate DRP is not available, an investor will not invest in companies that are more prone to default. If a company depicts lower default risk, this, in turn, will lower the future cost of raising capital for the company as such companies will get funds at lower DRP. The government does not pay a default premium except in unfavorable conditions to attract investors and pay higher yields.
Default Risk Premium Formula
DSR formula is represented as below –
DRP is the difference between the Risk-Free Rate and the Interest Rate charged by the lender. The interest rate comprises the following components – Inflation premium, maturity premium, liquidity premium, risk-free rate, and DRP. The risk-free rate is based on an asset that posses no risk. DRP generally deals with bonds such as treasury bonds, as these bonds are backed by the US government. The amount above the rate of treasury bonds that any investor would like to earn on investment is the default risk premium.
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How to Calculate Default Risk Premium?
DRP is the estimated return on a bond reduced by a risk-free return rate on investment. To calculate the DRP of a bond, the bonds’ coupon rate needs to be reduced by a risk-free return rate. This can be understood through the following steps.
- Step 1 – Rate of return for risk-free investment should be determined. The principal amount will grow with inflation while reducing deflation, and the security is backed by the US government. Say the rate of a risk-free security is 1%.
- Step 2 – If a corporate bond that we wish to purchase is offering 10% of the annual rate of return, then on substracting treasury’s rate of return from a corporate bond will be 10% – 1% that is 9%.
- Step 3 – Now, the estimated rate of inflation will be subtracted from the above difference. If inflation is estimated to be 4%, the value will be 9% – 4%, which is 5%.
- Step 4 – If any other premium is included in the bond-like liquidity premiums, subtract those premiums. For example, if the bond carries a liquidity premium of 1%, then on subtracting 1% from 4% will be arrived at 3% of the default risk premium.
ZYDUS Ltd. is issuing bonds with a 10% annual percentage yield. Now, if the risk-free rate is 1%, inflation of that particular year is estimated to be around 3%, and the liquidity and maturity premiums of the bonds are both 1%, adding all of these together with the sum totals to 6%. Hence, this bond’s default risk premium is equaled to 4% that is the annual percentage yield (10%) – other interest components (6%).
- Total Interest charged is 10%
- Other components of interest = (risk-free rate + inflation rate + liquidity premium + maturity premium)
- = 10% – (1%+3% + 1% + 1% )
- = 10% – 6%
- DRP = 4%
Factors that Determine Default Risk Premium
The following are the factors that determine DRP –
- Credit History – Any entity is considered trustworthy if it has paid previous debts on time with interest payments. Such companies or individual is presumed to have lower default risk, and therefore they get access to cheaper funds as lenders charge lower DRP from them.
- Credit Worthiness – Companies that possess poor credit rating and lower-grade bonds pay more default risk premiums. The companies are rated based on their financial performance by rating agencies such as Moody’s, Fitch, and S&P. Better the financial performance better is the credit rating. Higher credit rating results in a lower default risk premium, and hence the investor would not get high returns since the risk is less.
- Liquidity and Profitability – The company’s profitability helps banks know their creditworthiness before giving loans. The cash flows are examined to determine if the company has enough cash to meet its interest obligations.
- With a high default risk premium, the market compensates investors more for undertaking greater risk by investing in such companies.
- Novel and risky business investment offer above-average returns, which the borrower can use as an earning reward for investors on the risk of investment.
- The riskier a particular asset is, the greater is the required return from that asset.
- DRP helps in assigning a relative risk rating to a particular asset for the investor.
- DRP helps determine the level of risk an investor or lender has to undergo if a borrower defaults on the loan.
This has been a guide to what is Default Risk Premium and its definition. Here we discuss formula, purpose, and how to calculate default risk premium along with an example and advantages. You may learn more about financing from the following articles –