Finance Sample Essay on Default Risk Premium

Default Risk Premium

            A Default Risk Premium is the fraction of a supposed interest rate or yield from a bond that corresponds to a recompense for the likelihood of failure to pay (default) (Afik & Simon, pp. 1-10). In light of this definition, therefore, it is understood that the phrase is used to refer to the additional fee that a lender collects for the apparent possibility that whoever borrows the money will fail to pay back the given loan. From this definition, it is clear that default risk premium is significant and its relationship with the probability of defaulting is not monotonous. The default risk premium increases with an increased chance of defaulting, however, it declines when the chance of default reaches a specific level. Contrarily, the default premium declines when the possibility of default is low.

This implies that the default risk premium plays a key role when it comes to the pricing of credit derivatives, when the possibility of default is moderate, but its effect becomes less important when the possibility of defaulting becomes very high. The interest rate charged on bonds or loans depends so much on the default risk premium. If the market conditions are harsh, then the companies operating in the market would have to pay a higher default risk premium, otherwise, a lower default risk premium is paid. Since the United States dollar is one of the most commonly traded currencies in the international stock market, the trend of the default risk premium can be determined in regard to the market conditions in the United States or the dollar exchange rate. In the current situation, the international market environment in terms of trading the dollar is not tumultuous or turbulent. The risks that are likely to be incurred due to harsh market conditions are minimal. This trend has been so for the past months of the year and is likely to remain, thus the default risk premium is likely to remain low in the next six months.

            A yield curve risk refers to the danger or risk that is experienced due to a serious shift or change in the market interest rates due to making investments in fixed income instruments such as bonds. In this case, the records show that the yield rates are constant for the first six months at either 0.08 or 0.09 (U.S Department of the Treasury, 1). The yield curve will therefore remain flattened.

Works Cited

Afik, Zvika, and Simon Benninga. “Expected Bond Returns and the Credit Risk Premium.” Available at SSRN 2373845 (2014). < http://www.fma.org/Nashville/Papers/Afik-Benninga_EBR_1jan14_final.pdf >.

U.S Department of the Treasury. “Daily Treasury Yield Curve Rates.” Office of Debt Management. 2014. Web. 20 Mar 2014. < http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield >.