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.