Default risk premium: Difference between revisions
imported>Alicia-Marie Moore No edit summary |
imported>Alicia-Marie Moore |
||
| Line 4: | Line 4: | ||
==Default Risk Premium== | ==Default Risk Premium== | ||
In commencing this article I will provide the "textbook definition" of a '''Default Risk Premium''': | |||
"The portion of a nominal [[interest rate]] or [[bond]] yield that represents compensation for the possibility of default". | "The portion of a nominal [[interest rate]] or [[bond]] yield that represents compensation for the possibility of default". | ||
All [[investor]]s must always consider the possibility of credit risk or in other words, default. Investors are essentially risk takers since they are (and should be) equipped with the understanding of this possibility of default. | All [[investor]]s must always consider the possibility of credit risk or in other words, default. Investors are essentially risk takers since they are (and should be) equipped with the understanding of this possibility of default. A premium is then introduced primarily to protect the investor who recognizes that issuers may or may not make all the promised payments; therefore, a higher yield is acquired in order to compensate for the risk that is assumed. A common example of a bond that is more susceptible to default is known as a junk bond. This bond is rated at or lower than 'BB' and is considered a high risk investment due to its unlikelihood of meeting timely payments. | ||
Revision as of 09:18, 1 April 2008
Default Risk Premium
In commencing this article I will provide the "textbook definition" of a Default Risk Premium: "The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default".
All investors must always consider the possibility of credit risk or in other words, default. Investors are essentially risk takers since they are (and should be) equipped with the understanding of this possibility of default. A premium is then introduced primarily to protect the investor who recognizes that issuers may or may not make all the promised payments; therefore, a higher yield is acquired in order to compensate for the risk that is assumed. A common example of a bond that is more susceptible to default is known as a junk bond. This bond is rated at or lower than 'BB' and is considered a high risk investment due to its unlikelihood of meeting timely payments.
The 3 Elements
It is important to understand the following concepts regarding bonds. Treasury notes and bonds carry three vital characteristics:
- They are default free
- They are taxable
- They are extremely liquid.
Generally all bonds do not carry these specific features. Bonds issued by corporations or municipalities play by different rules.