Q1. What is risk premium? How is it measured? When there is an increase in the default risk on corporate bonds (due to bad economic conditions), what will happen to risk premium. Will it shrink or widen? Why?
(See pages 120-22 3rd edition) (see page 114-115 4th edition)
Default risk occurs when the issuer of a bond is unable or unwilling to make interest payments when promised or pay off ...view middle of the document...
Canadian Government bonds are considered to have no default risk, as its backed by the taxation power. These bonds are called default free bonds. The spread between the interest rates on bonds with default risk and default free bonds is called Risk Premium and it indicates how much additional interest people must earn in order to hold the risky bond. With an increase in default risk on corporate bonds, risk premium is raised and so will widen. If the default risk increases, the expected return decreases. The theory of Asset demand predicts that because the expected return on corporate bond falls relative to the expected return on the default-free Canada bond, while its relative riskiness rises, the corporate bond is less desirable and demand for it will fall. This leads to the equilibrium price to fall and shift left and since bond price is negatively correlated to interest rates, equilibrium interest rate rises. So a bond with default risk will always have a positive risk premium and an increase in default risk will raise the risk premium.