Default Risk Premium (DRP)
by MaestriThe risk that a borrower will default on a loan, which means not pay the interest or the principal, also affects the market interest rate on the security: the greater the default risk, the higher the interest rate. Treasury securities have no default risk, hence they carry the lowest interest rates on taxable securities in the United States. For corporate bonds, the higher the bond’s rating, the lower its default risk, and, consequently, the lower its interest rate.14 Here are some representative interest rates on long-term bonds during October 2001.
The difference between the quoted interest rate on a T-bond and that on a corporate bond with similar maturity, liquidity, and other features is the default risk premium (DRP). Therefore, if the bonds listed above were otherwise similar, the default risk premium would be DRP 6.5% 5.5% 1.0 percentage point for AAA corporate bonds, 6.8% 5.5% 1.3 percentage points for AA, and so forth. Default risk premiums vary somewhat over time, but the October 2001 ?gures are representative of levels in recent years.
Liquidity Premium (LP)
A “liquid” asset can be converted to cash quickly and at a “fair market value.” Financial assets are generally more liquid than real assets. Because liquidity is important, investors include liquidity premiums (LPs) when market rates of securities are established. Although it is dif?cult to accurately measure liquidity premiums, a differential of at least two and probably four or ?ve percentage points exists between the least liquid and the most liquid ?nancial assets of similar default risk and maturity.
Taken From : Five-Minute MBA – Corporate Finance
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