What are default risk premiums, and what do they measure?

Section 8.6

1.         What are default risk premiums, and what do they measure?

Default risk premiums are the amount of return that investors must be paid to purchase a security that possesses default risk compared to a similar risk-free investment. Default risk premiums, at any point in time, represent compensation for the expected financial injury for owning a bond plus some additional premium for bearing risk.

2.         Describe the two most prominent bond rating systems.

Default risk premiums tend to increase during periods of economic decline and to narrow during periods of economic expansion. This phenomenon is due to changes in investors’ willingness to own bonds with different credit ratings over the business cycle, the so-called flight to quality argument. Specifically, during periods of expansion when few defaults take place, investors are willing to invest in bonds with low credit quality to gain higher yields. In contrast, during tough economic times when many businesses fail, investors are concerned with safety. Accordingly, they adjust their portfolios to include more high-quality credits and sell off bonds with low credit ratings.  The two most prominent credit rating agencies are Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P).

3.         What are the three factors that most affect the level and shape of the yield curve?

The three factors that most affect the shape of the yield curve are the real rate of interest, the expected rate of inflation, and interest rate risk. If the future real rate of interest is expected to rise, it will result in an upward slope of the real rate of interest and consequently in an upward bias to the market yield curve. Similarly, increasing the expected rate of inflation will result in an upward-sloping yield curve, because long-term interest rates will contain a larger inflation premium than short-term interest rates. If these two variables are expected to decline in the future, the result will be a downward bias to the yield curve. In contrast, the longer a bond’s maturity, the greater the bond’s interest rate risk. Thus, interest rate risk premium always adds an upward bias to the slope of the yield curve, since the longer the maturity of a security, the greater its interest rate risk.

VI.   Self Study Problems

8.1       Calculate the price of a five-year bond that has a coupon of 6.5 percent and pays annual interest. The current market rate is 5.75 percent.

Solution:

                        0    5.75%        1                      2                      3                      4                      5

                        ├───────┼────────┼───────┼────────┼───────┤

                                                $65                  $65                  $65                  $65                  $1,065