Question

Is Credit Risk Premium the same as the Default Risk Premium? If not, please explain, graphically...

Is Credit Risk Premium the same as the Default Risk Premium? If not, please explain, graphically or through equations, the difference between the two.

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Answer #1

No Credit risk premium is not same as default risk premium:

Credit risk premium(CRP): It is defined as the difference between yield to maturity and expected return.

Equation:

Credit Risk Premium = Expected return on asset - yield to maturity.

Example: Premim paid by CDS buyer to CDS seller is an example of credit risk premium.

Default risk premium: Sometime companies are not able to pay interest on time. To address this issue companies company charge extra premium which is know as default risk premium.

Calculating the default risk premium
Default risk premium = annual percentage yield - other interest components.

If bond is paying 7% and other interest components like inflation, risk free rate are equal to 5% then default risk premium will be equal to 2%(7 - 5).

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