How Is a Default Risk Premium Determined?

In the world of finance, the default risk premium is the amount that an investor must be paid as compensation for investing in a security that could possibly default on its payment obligations. It is determined by first identifying some sort of risk-free investment and the rate that 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 yield the default risk premium. Investors that also want to include volatility in their calculations might also wish to multiply the risk premium by beta, which is a measurement of a security's volatility compared to others of its asset class.

The idea of a risk premium comes into play most noticeably when bonds are purchased by investors. An investor who purchases a bond generally is entitled to regular interest payments as well as the eventual return of the premium paid for the bond. This payback might not occur, however, if some financial calamity befalls the issuer of the bond, which could lead to them reneging on their payment obligations. Since this risk exists, investors usually demand a default risk premium be paid by the issuer as a way of balancing the arrangement.

When determining the default risk premium, there are two main percentage rates that must be considered. The first is the risk-free return, which is the average rate of return gained from an investment with few risks, such as Treasury bonds backed with government money. In addition, the average return, which is the amount of return that can be expected for investments of similar type, must also be determined. Taking the difference between these two rates yields the risk premium.

As an example, imagine that the risk-free rate chosen by an investor purchasing 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 extra seven percent of return on top of the three percent risk-free rate to compensate for the risk of default.

Of course, the volatility of a given security can also factor into the default risk premium. For that reason, investors may include beta in their calculation. 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 previous example, imagine that the bond the investor is buying has a beta of 1.2, meaning that it is 20 percent more volatile than others in its class, thereby increasing the risk. Multiplying the beta of 1.2 by the seven percent rate previously determined means that the risk premium for that bond jumps to 8.4.