Yield Curve and Default Risk Premium


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i would like to give a feedback to this post: Economic conditions definitely affect the default risk premium. The default risk premium is the higher rate necessary to compensate investors for taking on increased risks over and above risk-free investment options or assets like T-Bills (Madura, 2013). It basically covers the risk that the business or entity will go bankrupt before the investments mature or are recouped. How will it change over the next six months? Unfortunately, looking at historical trends is not a good predictor of the future for forecasting the default risk premium (Swedroe, 2012). It really depends a lot on the economic health. Research indicates that the best tool for forecasting risk premiums is “using macroeconomic models” (para.13). They are very difficult to predict, but using technical indicators may help. So, obviously, a healthy, growing, robust economy will in the eyes of investors minimize their risk of investing. Contrary to this, a stagnant, declining economy, with either high inflation or high unemployment, and unrest in the domestic and international markets will increase the risk of investing in the eyes of the investors. This makes sense. In the second example, these investors may stick closer to risk-free investments, like T-Bills, or demand higher rates and yields to cover the risk associated with other assets or investments. I see turbulence in the domestic and international markets in the next six months. I believe the default risk premium will necessarily increase to get investors to continue investing in these riskier assets and investments. There are a lot of things happening in the US and around the world right now. Unrest in Ukraine, and the Middle East region, especially in Iraq, Iran, and Syria contributes to the unease. The increase of terrorism in the Middle East and Africa are also factors. Refineries in some areas like Iraq may be in jeopardy of being lost to terrorists. The interruption in the world supply of oil may exacerbate inflation, and hamper manufacturing and distribution of products and services. Chinese and North Korean aggression in the APAC region is another inhibiting factor. At home, dealing with issues like the increasingly large budget deficit, debt load, illegal immigration, the Affordable Care Act, higher minimum wages, the massive amounts of General Motors recalls may cause disruptions in the domestic economy, as well. Furthermore, regarding the US, the increasing budget deficit, and huge debt load may put the US at risk of bankruptcy or insolvency. Political wrangling will determine the outcome of many of these issues. All of these factors affect investors when they are looking at what to do with the money. The question for investors is whether their investments are going to be secure or is there a significant risk of losing all of it to bankruptcy? I think investors are going to demand a higher default or risk premium for their continued investment over the next six months. As a result, the Treasury’s yield curve will trend upward as the interest rates rise. Investors closely monitor this yield curve in hopes of estimating how the future interest rates will change (Madura, 2013). It is also used to “estimate the annualized cost of funds for different maturity levels” (p.55). The yield rate takes into account several different factors including the default risk premium, the loss of liquidity premium, tax adjustments, and the risk-free rate of return. During times of unrest and poor economic conditions, investors want to stay liquid, so they will demand more of a return on their investments for losing liquidity. I’m not optimistic about the next six months. Jun 19 2014 10:52 PM


Solution ID:608801 | This paper was updated on 26-Nov-2015

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