Final answer:
The maturity risk premium compensates for interest rate risk over a bond's longer term, while the default risk premium covers the risk of payment default. These are crucial components of the interest rates on corporate bonds and influence the expected rate of return on these investments.
Step-by-step explanation:
The maturity risk premium (MRP) is the additional return that investors demand for holding a longer-term bond, which compensates them for the greater risk of price fluctuations due to changes in interest rates over time. The default risk premium (DRP) is the extra return that investors require for holding a bond that has a risk of default, which is the risk that the issuer will not be able to make the promised payments.
The existence of these premiums is grounded in the concept that investing in corporate bonds involves certain risks, including the potential inability of the company to repay its debt (default risk), and the sensitivity of bond prices to changes in interest rates (interest rate risk). The expected rate of return is influenced by these premiums, as they are built into the interest rates that investors require to lend their money. Investors accept these risks in hopes of earning returns above those available from risk-free investments.
Throughout an investor's life, the acceptable level of investment risk might change. In the early part of a career, it might be advisable to take on higher risks as there is more time to recoup potential losses, but as one nears retirement, a more conservative approach is often recommended.