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FINANCIAL MARKETS AND INTEREST RATES
Risk
There are several types of risk that can be included in the risk
premium. Usually, it is difficult to quantify what percentage of the
risk premium is associated with each type of risk. Let's look at three
risks that affect the amount of the risk premium: counterparty risk,
liquidity risk, and interest rate risk.
Counterparty
(default) risk
Counterparty (default) risk is the chance that the borrower will not be
able to pay the interest or pay off the principal of a loan. This risk can
influence the level of interest rates. It is generally considered that
U.S. Treasury securities have no default risk
the U.S. government will always pay interest and will repay the
principal of its borrowings. Therefore, the difference in price
between a U.S. Treasury security and another corporate bond with
similar maturity, liquidity, etc. may be the risk premium for assuming
counterparty risk.
Several ratings companies identify and classify the creditworthiness of
corporations and governments to determine how large the risk
premium should be. They apply specific ratings such as AAA or BBB
to indicate the likelihood of default by the borrowing entity.
A corporation with a AAA rating will have a smaller default risk than a
firm with a BBB rating and, therefore, will be able to borrow capital at
a lower interest rate (other factors being equal).