Certified Financial Management Specialist Practice Exam

The difference in interest rates attributed to the risk of default is known as?

1. Inflation Premium (IP)

2. Liquidity Premium (LP)

3. Default Risk Premium (DRP)

4. Maturity Rate Premium

The correct answer is: Default Risk Premium (DRP)

The concept of the difference in interest rates that is attributed to the risk of default is known as the Default Risk Premium (DRP). This premium is essentially the additional yield that investors require to compensate for the risk that a borrower may be unable to make the required payments on a loan or bond. In practice, when investors assess a potential investment, they consider the likelihood that the issuer will default on their obligations. A higher perceived risk of default leads to a higher default risk premium, meaning that borrowers with poorer credit histories or those in uncertain financial positions will typically have to offer higher interest rates to attract investment. This reflects the additional risk taken on by lenders when they choose to invest in securities issued by these borrowers, as they need to balance potential returns against the probability of loss. This understanding helps gauge the creditworthiness of different borrowers and the pricing of financial instruments. The other options - Inflation Premium, Liquidity Premium, and Maturity Rate Premium - refer to different factors that affect interest rates but do not specifically address the risk of default. Inflation Premium relates to the expected decrease in purchasing power over time, Liquidity Premium addresses the potential difficulty in selling an investment quickly without losing value, and Maturity Rate Premium pertains to the risk associated with the length