During periods of economic uncertainty, what is likely to happen to the default risk premium?

• A. It will be eliminated entirely by government intervention.
• B. It will decrease because borrowers become more reliable.
• C. It will increase as lenders demand higher compensation for risk.
• D. It will remain unchanged regardless of economic conditions.

Answer: (C)

Verified step by step guidance

1. Understand the concept of the default risk premium: it is the additional return lenders require to compensate for the risk that a borrower might fail to repay a loan.
2. Recognize that during periods of economic uncertainty, the likelihood of borrowers defaulting on their loans generally increases due to unstable income and financial conditions.
3. Since lenders face higher risk, they demand a higher default risk premium to compensate for the increased probability of default.
4. Government intervention may help reduce risk in some cases, but it rarely eliminates the default risk premium entirely because lenders still face uncertainty about individual borrower behavior.
5. Therefore, the default risk premium tends to increase during economic uncertainty as lenders seek greater compensation for the elevated risk.