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Default Risk Premium
A Treasury bond maturing in 5 years has a yield of 4 percent. A 5-year corporate bond has a yield of 7 percent. Consider that the liquidity premium on the corporate bond is 0.5 percent. If this is so, what is the default risk on the corporate bond?
A default risk premium is effectively the difference between a debt instrument’s interest rate and the risk-free rate. The premium exists to compensate investors for an entity’s likelihood of defaulting on their debt. It 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.
The premium is determined by Credit history, Liquidity and profitability, Asset ownership
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