Final answer:
Investors demand a risk premium to compensate for the uncertainty of returns associated with the risk of the investment. Components of an interest rate include compensation for delayed consumption, adjustment for inflation, and a risk premium.
Step-by-step explanation:
Investors require a risk premium as compensation for bearing the risk associated with the uncertainty of returns. When an investor buys a bond, they expect to earn a return on their investment.
This return on investment is influenced by various factors, and we can typically breakdown the interest rate into three key components:
- Compensation for delaying consumption, which is essentially the opportunity cost of not being able to use the invested funds for other purposes.
- An adjustment for inflation, which accounts for the expected rise in prices over time that can erode the real value of future payments.
- A risk premium, which is added to account for the riskiness of the borrower. The higher the perceived risk, the larger the required risk premium, as investors need to be compensated for the additional risk they are taking on.
For example, if a financial investor believes that an investment is particularly risky, they might demand a higher interest rate to compensate for this risk.
If the appropriate interest rate for valuing future payments is determined to be 15%, this rate includes not just the return based on other financial investment opportunities (the opportunity cost) but also a higher risk premium that accounts for the extra risk.