Question

What are default risk premiums, and what do they measure?

Answer 1

Default risk premium or (DRP) represent the extra return that the borrower must pay the lender for assuming the extra or default risk. It is commonly used in the case of bonds. DRP compensates the investors or the lender in case the borrower defaults on their debt.Investors with poor credit record must pay a higher interest rate to borrow money. A lender would charge a higher DRP if they feel borrower have a higher risk of being unable to pay the debt.

One can say that the DRP give borrowers a greater incentive not to default on the debt.Without an adequate DRP, an investor would not invest in companies that have a higher chance of default. By not defaulting on the debt, a company lowers its perceived default risk, and this, in turn, lowers the company’s future cost of raising capital.DRP is basically a difference between the risk-free rate and the interest rate charged by the lender. For instance, if a company comes up with a 10-year bond at 6% and the comparable return from a U.S. Treasury bond of a 10-year maturity is 4%, then the DRP is 2%.

A default risk premium is effectively the difference between a debt instrument's interest rate and the risk-free rate. ... The default risk premiumexists to compensate investors for an entity's likelihood of defaulting on their debt.