How Do You Calculate A Default Risk Premium?
The risk premium is the rate which an investor needs over and above the rate for a risk-free asset in the same asset class. You can look at this as being roughly the equivalent to the difference in price paid for brand name products. We pay a premium for quality, which reduces our risk. In this same way, investors expect to be compensated more for higher risk assets. The more risky the investment the higher the risk premium. Determine a risk-free asset in the same asset class. Let’s assume we are comparing securities. The rate of risk is dependent on the institution issuing the securities. A new technology company will have a higher degree of risk than a 100-year old utility company. For this reason, treasury securities are often used as a proxy for the risk-free rate, as they are issued by the United States government. Determine the duration. If you are looking to find the default risk premium for a 1-year asset, it will be different than the risk premium for a 10-year asset. This is
