Question

31) What is default risk? How is it different from default risk premium? Describe two ways an investor can evaluate a bond issuer’s risk of default.   

（Please explain in details, the more the better）

Answer 1

Let's first understand why person defaults, in laymen language the incapacity to pay for the dues leads an individual to the default of any payment.

Now will see further, Default Risk is the probability where an individual or the company unable to make the debt payment to the lender, however the default risk can be changed based on the economic changes and in the change in the financial situation of the company or an individual.

There are various other factors which leads to to the default in the making payments of debt such as recession, increased pricing, increased competition.

There are two types of default risk which are as follows:

Investment Grade- This is considered to have the lower default risk.

Non Investment Grade- This is having higher yield but having the higher default risk attached to it.

Default Risk Premium - It represents 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, Default Risk Premium compensate the investors or the lender in case the borrower on payment of the debt.

To calculate Default Risk Premium we will follow as

= Interest Rate charged - Risk free rate of Interest

To understand this will see one example,

A Bank comes up with a 5 year bond @ 7% and the comparable returns From a Government Treasury Bonds of a 5 year maturity is 5% then the calculation will be as follows

= 7% - 5%

= 2% will be the Default Risk Premium.