Question

1. How do we measure the default risk in government bonds and treasury bills?

Answer 1

Default in loan or bond takes place when the borrower cannot pay the interest or the principal on the date he is due to pay.The lendors charge higher interest rate when default risk is more.Some bonds have no chance of default while there are some which have high chance of default.A part of bond's interest rate is to compensate the investor for the risk of default involved with it.The default premium is the difference in the amount between a corporate bond and government bond upon maturity.The default premium will be more if the company is in financial problem.The default premium varies with the fluctuations in business cycle . During economic prosperity ,the investors take risk .and require less return from lower rated bonds whereas during economic slowdown ,the investors want security and want high return from risky low rated bonds.There are various rating organisations like Standard and poor ,which measures the default risk and try to find the quality of the bond.Default rates are more for bonds which are rated higher and low for bonds which are rated lower.

Treasury bills are short term securities of the US government.Treasury bills are said to be free of default risk because they are fully backed and supported by the US government .Every investment involves certain risk and treasury bills are considered to be almost risk free because they are fully backed by government and also during financial distress the government never defaults in debt.The government has the power to print money to clear its debt.Treasury bills are safe and return is guaranteed.Treasury bills are short term securities for a period of a year and there is no interest rate risk as they are paid on par value.