Question

what is the significance of the risk premium in developing an investor's nominal interest rate on a corporate bond? How does the risk premium affect the bond's coupon interest rate?  

Answer 1

Risk premium is the premium which is demanded by the investor for taking additional risk for investment into various securities and when the investor will be investing in the corporate Bond he will be trying to demand a higher rate of interest than the risk free real rate of interest because he will be trying to discount various kind of risk associated with the corporate Bond and these risk will be leading to risk related to liquidity of the corporate Bond and risk related to maturity of the corporate Bond and risk related to default, so he will be trying to discount all the risk in advance and he will demand a premium from company in order to invest into these corporate bonds so that he can be getting a higher rate of interest for investment into these securities for their uncertainty associated with them.

It will help the investor in order to hedgr himself from any kind of adverse effect on his rate of return because he will try to demand a higher rate of return for Risk from the bond issuer for investing in it.

Risk premium will be leading to increase the coupon interest rate of the bond because investor will always want a higher Risk Premium for taking various kinds of risk and the ad there will be higher risk in the environment the bond risk will always be demanding a bond risk premium to compensate for the risk and since it is a Premium, it will always be added to the normal coupon rate making the bond coupon rate higher.