Default risk premium is the compensation paid to an investor for investing in a security that may default on its payment obligations. It is determined by subtracting the risk-free return from the average return for securities of the same type, and can be influenced by a security’s volatility. Investors typically require a default risk premium when buying bonds.
In the world of finance, the default risk premium is the amount that must be paid to an investor as compensation for investing in a security that could possibly default on its payment obligations. It is determined by first identifying some type of risk-free investment and the rate it returns to investors. This rate is subtracted from the average rate of return, for securities of the same type as the one being studied, to obtain the default risk premium. Investors who also want to include volatility in their calculations could also multiply the risk premium by beta, which is a measure of a security’s volatility compared to others in its asset class.
The idea of a risk premium comes into play most notably when investors buy bonds. An investor who buys a bond is generally entitled to regular interest payments, as well as an eventual return of the premium paid on the bond. However, this recovery of the investment may not occur if some financial calamity befalls the issuer of the bond, which could lead it to default on its payment obligations. Since this risk exists, investors typically require the issuer to pay a default risk premium as a way to balance the deal.
When determining the default risk premium, there are two main percentage rates that need to be considered. The first is the risk-free return, which is the average rate of return earned on an investment with little risk, such as government-backed Treasury bonds. In addition, the average return, which is the amount of return that can be expected for investments of a similar type, must also be determined. Taking the difference between these two rates produces the risk premium.
As an example, imagine that the risk-free rate chosen by an investor buying a bond is three percent. The average rate of return for the type of bond being purchased is 10 percent. In that case, the default risk premium is 10 percent minus three percent, or seven percent. This means that the investor is asking for an additional seven percent return on top of the three percent risk-free rate to offset the risk of default.
Of course, the volatility of a given security can also influence the default risk premium. For that reason, investors can include beta in their calculations. Beta, which is based on a scale of one, measures how much more or less volatile a security is compared to others in the same class. Continuing with the example above, imagine that the bond the investor is buying has a beta of 1.2, which means it is 20 percent more volatile than others in its class, increasing risk. Multiplying the 1.2 beta by the previously determined rate of seven percent means that the risk premium for that bond jumps to 8.4.
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