Introduction to Finance

DISCUSSION QUESTION 3
Given the current size and continued growth of the U.S. national debt, should Treasury 
securities be viewed as free from default risk?
LEARNING ACTIVITY
Go to the website of the Council of Economic Advisors, http://www.whitehouse.gov/cea/
pubs.html, and access the Economic Report of the President. Next, access the statistical 
appendix tables and fi nd current infl ation rates based on the consumer price index for 
all items and for when food and energy prices are excluded.
speculative infl ation 
caused by the 
expectation that prices will continue 
to rise, resulting in increased buying 
to avoid even higher future prices
administrative infl ation 
the 
tendency of prices, aided by union-
corporation contracts, to rise during 
economic expansion and to resist 
declines during recessions

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C H A PT E R 8 Interest Rates
8.6
Default Risk Premiums
FINANCE
Investors are said to be “risk averse”; that is, they expect to be compensated with 
higher returns for taking on more risk in the form of greater uncertainty about return variab-
ility or outcome. This is the pillar of fi nance, known as the risk-return principle, or “higher 
returns are expected for taking on more risk” principle. 
Default risk
is the risk that a 
borrower will not pay interest and/or repay the principal on a loan or other debt instrument 
according to the agreed contractual terms. The consequence may be a lower-than-expected 
interest rate or yield or even a complete loss of the amount originally lent. The 
default 
risk premium
is an added market interest rate component that provides higher expected 
compensation for taking on default risk. The premium for default risk will increase as the 
probability of default increases.
To examine default risk premiums for debt securities, it is necessary to hold some of the 
other components of market interest rates constant. Referring to equation 8.3, we can develop 
a procedure for measuring that portion of a market interest rate (
r
) attributable to default risk. 
Recall that the market interest rate is a function of a real interest rate, an infl ation premium, a 
default risk premium, a maturity risk premium, and a liquidity risk premium.
First, we constrain our analysis to the long-term capital markets by considering only long-
term Treasury bonds and long-term corporate bonds. By focusing on long-term securities, the 
maturity risk will be the same for all the bonds and can be set at zero for analysis purposes. We 
have also said that the liquidity premium is zero for Treasury securities, because they can be 
readily sold without requiring a substantial price discount. Corporate securities are less liquid 
than Treasury securities. However, we can minimize any possible liquidity premiums by con-
sidering the bonds of large corporations. This also allows us to set the liquidity premium at 
zero for analysis purposes.
For the following example, assume that the real rate is 1 percent, infl ation is expected 
to average 2 percent, the market interest rate is 3 percent for long-term Treasury bonds, and 
high-quality corporate bonds have a 5 percent market interest rate. Using equation 8.3, we 
have the following: 
r
= RR + IP + DRP + MRP + LP
5% = 1% + 2% + DRP + 0% + 0%
DRP = 5% – 1% – 2% – 0% – 0% = 2%
Since the 3 percent Treasury bond represents the risk-free rate of interest, subtracting 
the 1 percent real rate results in a long-term average annual infl ation premium of 2 percent. 
Another way of looking at the default risk premium (assuming zero maturity risk and liquidity 
premiums) is that it is the diff erence between the interest rates on the risky (corporate) and 
risk-free (Treasury) securities. In our example, we have,
DRP = 5% – 3% = 2%
Thus, investors require a 2 percent premium to hold or invest in the corporate bond instead of 
the Treasury bond.
Another corporate bond with a higher default risk may carry an interest rate of, say, 7 
percent. If the other assumptions used above are retained, the DRP would be,
7% = 1% + 2% + DRP + 0% + 0%
DRP = 7% – 1% – 2% – 0% – 0% = 4%
Alternatively, we could fi nd DRP as follows:
DRP = 7% – 3% = 4%
Thus, to get investors to invest in these riskier corporate bonds, a default risk premium of 
four percentage points must be off ered above the interest rate, or yield, on Treasury bonds.
The examination of actual default risk premiums in