An interest rate (r) is the rate of return that equates the value of different cash flows on different dates. For any given investor, r is the compensation they receive for tying up their money for a specified period of time. In aggregate, interest rates are set by supply and demand in the markets. In this context, r can be viewed as a real, risk-free interest rate plus compensation for four specific risks.
r = Real risk-free interest rate + Inflation premium + Default risk premium +
Liquidity premium + Maturity premium
The real, risk-free interest rate represents the return of a completely risk-free security in the absence of inflation.
The inflation premium represents the average inflation rate expected during the term of the contract. It compensates investors for the loss of purchasing power over time.
Taken together, the real, risk-free interest rate plus the inflation premium equal the nominal risk-free rate. In many countries, short-term government-issued bonds can be considered risk-free, and in these cases the rate on these securities reflects the nominal risk-free rate. For example, at the time of this writing the interest rate on a 3-month US Treasury bill is 0.08%, and for US investors this could be considered the nominal risk-free rate of return.
The default premium compensates investors for the possibility that the borrower fails to make a contracted payment on time. As a borrower’s finances become less stable, they will face a higher default premium.
The liquidity premium compensates for the loss in value should a security need to be sold immediately. For the US government, their bonds are traded frequently throughout the day, so no liquidity premium is necessary. However, consider a bank that loaned money to a small local business. If they wished to exit the loan before it matured, they may face a difficult time finding someone willing to hold the contract. To find a buyer, they may have to sell the loan for less than the present value of its expected cash flows. This reduction in value would represent a liquidity premium for the buyer, as they would be entitled to the future cash flows for a smaller outlay than the default risk alone would justify.
The maturity premium compensates investors for the fact that longer-term contracts are more sensitive to changes in interest rates than short-term contracts. At the time of this writing, the rate on a 30-year US Treasury bond is 1.83% per year. Compared to the 0.08% 90-day rate, this represents a maturity premium of 1.75% per year for the investor willing to hold the longer-term bond.