Default Risk Premium

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.

Explanation

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.

Purpose

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 –

Default-Risk-Premium

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For eg:
Source: Default Risk Premium (wallstreetmojo.com)

DRP = Interest Rate Charged by Lender – Risk-Free Rate of Interest

DRP = Total Interest Charged – Other Component Of Interest

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 premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price.read more, 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.

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 Coupon Rate The coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read moreneeds to be reduced by a risk-free return rate. This can be understood through the following steps.

Example

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%).

Default Risk Premium Example 1

Solution

Here,

  • Total Interest charged is 10%
  • Other components of interest = (risk-free rate + inflation rate + liquidity premium + maturity premium)
Example 1.2
  • = 10% – (1%+3% + 1% + 1% )
  • = 10% – 6%
  • DRP =  4%

Factors that Determine Default Risk Premium

The following are the factors that determine DRP –

Advantages

  • 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.

Recommended Articles

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 –