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Default Risk Premium Formula:
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The Default Risk Premium is the additional return investors demand for bearing the risk that a corporate bond issuer might default on its payments. It represents the difference between the yield on a corporate bond and the yield on a risk-free government bond (UK gilt).
The calculator uses the simple formula:
Where:
Explanation: This calculation measures the extra compensation investors require for taking on the additional default risk of corporate bonds compared to risk-free government securities.
Details: The default risk premium is a crucial metric for bond investors, financial analysts, and portfolio managers. It helps assess the credit risk of corporate bonds, informs investment decisions, and provides insight into market perceptions of corporate creditworthiness.
Tips: Enter the corporate bond yield and UK gilt yield as percentages. Both values should be positive numbers representing annualized yields.
Q1: Why use UK gilts as the risk-free rate?
A: UK government gilts are considered virtually risk-free because they're backed by the UK government, which has the power to tax and print currency to meet its obligations.
Q2: What factors influence the default risk premium?
A: The premium varies based on the issuing company's credit rating, financial health, industry conditions, economic outlook, and overall market risk appetite.
Q3: How does the default risk premium change over time?
A: The premium typically widens during economic downturns or financial crises when default risks increase, and narrows during stable economic periods.
Q4: Are there limitations to this simple calculation?
A: Yes, this simple difference doesn't account for differences in bond maturity, liquidity, or tax treatment between corporate bonds and gilts.
Q5: How should investors use the default risk premium?
A: Investors should compare the premium against historical averages, similar companies, and their own risk tolerance when making investment decisions.