Does anyone understand the difference between the spread and the premium - the spread is added to the discount rate to reflect the specific risk and the premium is “the premiums reflect compensation for specific risk”. Can I use these terms interchangeably?
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Based on the reduction in policy rates and the flattening of the interest rate futures curve, Rahman is virtually certain to reduce the short-term rate component. Steepening of the yield curve (10-year yield barely responded to the 50 bp rate cut) indicates an increase in both the term premium and the credit premium. Declining confidence also suggests a higher term premium. Widening of credit spreads is also indicative of a higher credit premium. However, the increase in loan defaults suggests that credit losses are likely to be higher next year as well, since defaults tend to cluster. All else the same, this reduces the expected return on corporate bonds/loans. Hence, the credit premium should increase less than would otherwise be implied by the steeper yield curve and wider credit spreads.
One way to think about it is to see there is a term structure to credit spreads.
That is to say the steepeneing of a yield curve is not only related to rates, but also to the incremental spread investors demand to hold later maturities.
That is, as i understand, what the premium refers to, ie higher rates could not only steepen the benchmark/reference curve, but it could lead to a widening of the credjt spreads themselves.
Here’s what the curriculum says (2022 Level III curriculum, volume 1, reading 4, §3.2.3, p. 171):
“The credit premium is the additional expected return demanded for bearing the risk of default losses—importantly, in addition to compensation for the expected level of losses. Both expected default losses and the credit premium are embedded in credit spreads.”
So . . . it appears that the credit premium compensates only for unexpected default losses, but they certainly aren’t clear on that point.
Thanks Again! i think I should view the credit spread as expected premium and credit premium as credit spread plus extra for unexpected events. BTW i live in Los Angeles and have an exam on 3rd of sept. after that definitely.
My pleasure.
Whereabouts in LA?
I grew up in Westchester.