Default Risk Premium Calculator

| Added in Business Finance

What is Default Risk Premium and Why Should You Care?

Ever wondered why investing in a Treasury bond feels like a comfy old sweater, while diving into corporate bonds gives you a bit of anxiety? Well, that feeling is your inner finance guru acknowledging something called the Default Risk Premium.

Essentially, the Default Risk Premium is the difference between the return on an investment asset and the return on a risk-free asset (like Treasury bonds). It's a measure of the risk associated with an investment compared to virtually risk-free alternatives.

Why should you care? Because this premium provides a quantifiable way to gauge the added risk you are taking on when you stray from those trusty Treasury bonds.

How to Calculate Default Risk Premium

Calculating the Default Risk Premium is straightforward. Here's how:

Step-by-Step Guide

  1. Figure out the annual return rate of the asset you're considering. This could be anything from a corporate bond to a high-yield saving account.
  2. Identify the return rate of the risk-free asset. Typically, this is a Treasury bond, which usually returns around 1-2%.
  3. Subtract the return rate of the risk-free asset from the return rate of your investment asset.

Formula

[\text{Default Risk Premium} = \text{Return Rate of Asset} - \text{Return Rate of Risk-Free Asset}]

Calculation Example

Let's say you're looking at a corporate bond offering a 5% annual return. Comparatively, a 1-year U.S. Treasury bond offers a 1.5% return. What's the Default Risk Premium here?

[\text{Default Risk Premium} = 5% - 1.5% = 3.5%]

Where:

  • Return Rate of Asset is 5%.
  • Return Rate of Risk-Free Asset is 1.5%.

So, your Default Risk Premium comes out to 3.5%. That's the added risk—and potential reward—you're taking on.

Return Rate of Asset Return Rate of Risk-Free Asset Default Risk Premium
5% 1.5% 3.5%

Key Points to Remember

  • Higher Default Risk Premium means higher risk but also higher potential returns.
  • Always compare similar terms (like bonds with similar durations) for a more accurate assessment.

Frequently Asked Questions

The Default Risk Premium is the difference between the return on an investment asset and the return on a risk-free asset like Treasury bonds. It measures the additional compensation investors require for taking on the risk of potential default.

It provides a quantifiable way to gauge the added risk you are taking when investing in assets other than risk-free alternatives. Higher premiums indicate higher risk but also potentially higher returns.

Treasury bonds issued by stable governments are typically considered risk-free assets because they have virtually no default risk. In the US, Treasury bills and bonds are the standard benchmark.

A higher Default Risk Premium means the investment carries more risk compared to risk-free alternatives. While this means potentially higher returns, it also means a greater chance of losing your investment if the issuer defaults.