How to 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.
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Instructions
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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.
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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 because time usually increases the amount of risk and therefore requires more return. Let's say you are looking at 10-year bonds.
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Look up the treasury rate for 10-year treasury bonds on the U.S. Treasury site (see Resources). As of January 11, 2010, the rate of return on a 10-year U.S. Treasury bond is: 3.85 percent.
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Calculate an average return for the market. In order to find a default risk premium, we need to know what the average return is for securities in this class. This is difficult to determine, so investors and economists use 12 percent as a proxy for the overall average return for the equity market. This number might change if you're working with real estate or commodities.
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Subtract the risk-free rate from the average market return over the past 100 years for a default risk premium that can be used for equity securities held an average of 10 years.
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