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.
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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.
Presumably, the government of a country does not pay a default premium. However, in unfavourable conditions, even the government had to pay higher yields to attract investors.
How to Calculate it?
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%.
There is another more comprehensive way of calculating DRP. An interest rate is made up of several components and DRP is one of those components. So, subtracting all the components (except for DRP) from the interest rate gives the DRP.
Usually, an interest rate is made of following components – risk-free rate, inflation premium, liquidity premium (compensates for investing in less liquid securities like bonds), maturity premium (compensates for investing in securities that will mature many years into the future ) and DRP. So, DRP, in this case, is = Interest rate Less other interest components.
For example, Company A is issuing bonds at 8%. If the risk-free rate is 0.5%, inflation is 2%, liquidity and maturity premiums are both 1% each, then the DRP is (8% – (0.5%+2%1%+1%)) 3.5%.
What Determines Default Risk premium?
Usually, companies with lower grade bonds or poor credit rating pay more default premiums. Rating agencies like Moody’s, S&P, and Fitch rate the corporate bonds or companies on the basis of their financial performance. Better financial performance means more safety, and in turn, a higher credit rating.
A higher credit rating would lead to the lower default risk premium, means investors would not get higher returns as the risk is less.
If an individual or a company has paid previous debts in time along with the interest payments, it suggests that the entity is trustworthy. Such entities are presumed to have lower default risk, and thus, can borrow money at a lower interest rate. Similarly, the opposite is also true. A person with a poor credit history will have higher default risk and thus, would be a charged a higher DRP.
Liquidity and profitability
This is part of a company’s creditworthiness. Before giving a loan, a bank examines the company’s recent financial statements to determine the company’s profitability. This helps the bank to know if the entity will be able to pay the debt or not. Also, cash flows are examined to determine if the company is generating enough cash to meet the regular interest obligations.