Certified Financial Management Specialist Practice Exam

Which premium reflects the difference in interest rates due to default risk?

1. Liquidity Premium (LP)

2. Default Risk Premium (DRP)

3. Maturity Rate Premium

4. Nominal Risk-Free Rate

The correct answer is: Default Risk Premium (DRP)

The Default Risk Premium (DRP) is the additional yield that investors require to hold a security that carries default risk compared to a risk-free asset. This premium reflects the potential for loss due to the possibility that the borrower may fail to make payments or default on the loan. Investors demand this premium as compensation for taking on the additional risk associated with lending to borrowers who may be less likely to meet their obligations. The DRP is crucial in the pricing of bonds and loans, as it differentiates risk levels and influences the overall cost of debt for borrowers. The other options relate to different risk factors or characteristics of an investment. For instance, the Liquidity Premium pertains to the compensation investors require for holding assets that may not be easily sold or converted to cash without a loss in value. The Maturity Risk Premium is concerned with the additional risk associated with the longer time horizons of investments, while the Nominal Risk-Free Rate signifies the return expected from an investment with no risk at all, typically represented by government securities. Each of these premiums addresses distinct facets of investment risk, making the Default Risk Premium the correct answer regarding the difference in interest rates specifically due to default risk.