The interest rates are market determined by the forces of demand and supply. The investors are the suppliers of capital, and the borrowers are demanders of capital. The interest rate for different investments can be different depending on the riskiness of that investment. The interest rate can be composed of a real risk-free interest rate and four risk premiums for bearing different types of risk.
r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium
The real risk-free rate is the single-period interest rate for a risk-free security without the presence of any inflation. It reflects the time preference of individuals for current versus future real consumption.
The inflation premium is the premium that compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the investment. Since inflation reduces the purchasing power of a unit of currency, investors require this premium for compensating for that reduction. The sum of real risk-free interest rate and inflation premium is the nominal risk-free interest rate. The interest rate on the short-term Government debt is considered as nominal risk-free interest rate in different countries.
The default risk premium compensates investors for the possibility that the borrower will fail to make promised full payments when these payments are due. The riskier a security, the higher is the default risk premium.
The liquidity premium compensates investors for the illiquidity of the investment. The liquidity risk can be thought of as loss in the value of the security on quickly changing it to cash by selling it. The higher is the impact on the price due to the illiquidity of the security; the higher is the liquidity premium. The assets that trade frequently (government bonds, equity securities) are more liquid than the infrequently traded assets (real estate) or the assets that do not trade at all (private equity).
The maturity premium compensates investors for the increased sensitivity of the market value of the asset to the change in the market interest rates. The longer is the maturity, the greater is the maturity risk, and the greater is the maturity premium. The short-term Treasury bills have smaller maturity risk as compared to long-term Treasury bonds.
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