Your Ask Joey ™ Answer

What are the types of interest rate premiums related to interest rate risk?

First off, let’s make sure we understand what interest rate risk is. Interest rate risk is that risk that interest rates change, and a company/individual is negatively impacted (i.e. lose money) as the value of their bonds or fixed-rate investments may decline.

To compensate investors for taking on additional interest rate risk, risk premiums may be added to the risk-free rate to arrive at the interest rate that is actually charged by the lender (i.e. their required rate of return). There are various types of risk premiums which would include maturity risk premiums, inflation risk premiums, liquidity risk premiums, and default risk premiums:

Maturity risk premium – Maturity relates to the date that the bond must be repaid. The further out the maturity date is, the bigger the risk is for the lender. For example, if a bond has a term of 5 years vs 30 years, there would be incremental risk for the extra 25 years that the bond is outstanding. The longer the maturity period, the higher the maturity risk premium that is charged.

Inflation risk premium – Inflation risk is the risk that inflation rises or falls more than what is expected in the market. So if the asset or investment is exposed to inflation, then a premium will be added to account for inflation risk.

Liquidity risk premium – Liquidity is how easily an investment or asset can be converted to cash. So if the investment cannot be easily converted to cash, then a premium will be charged to account for this risk.

Default risk premium – This is the additional maturity risk premium paid by a borrower to account for the risk that the borrower defaults and does not pay back the money loaned. Most corporations are charged a default risk premium. The default risk premium that is charged is typically based on the credit ratings from agencies such as Moodys, S&P, or Fitch. The only borrower that is not typically charged a default risk premium would be the U.S government.

From a lenders perspective, they will analyze the these risks and determine the premiums that should be added to the risk-free rate. That is how the lender arrives at the interest rate that is charged to borrow the money.


Back To All Questions

You might also be interested in...

  • CECL Excel Workbook

    If you would like to use the Excel workbook that was used to create the Universal CPA lecture on CECL for debt securities, please click the link below to download the Excel workbook: CECL Calculation workbook (Universal CPA Review)

  • Journal Entry for Direct Materials Variance

    Journal Entry for Direct Materials Variance In the current year, Mission Burrito budgeted 6,000 pounds of production and actually used 4,000 pounds. Material cost was budgeted for $5 per pound and the actual cost was $8 per pound. What would the debit or credit to the direct material efficiency variance account be for the current...

  • Understanding Variance Analysis

    Variance Analysis Variance analysis is a method for companies to compare its actual performance vs its budgeted amount for that cost measurement (related to the flexible budget). The differences between the standard (budgeted) amount of cost and the actual amount that the organization incurs is referred to as a variance. By analyzing variances, the company...