What are the determinants of ones perception of risk?
First, there is the ability of the borrower to pay back the money – default effect. This is why we have bond rating companies to assess a potential borrower’s fiscal health. The difference between corporate Aaa bonds and federal government bonds can be in large part attributed to the market assuming that the default risk for corporations is higher than it is for the government. The default effect is also influenced by the ease with which a lender can recoup its losses in the event that the borrower can not meet the repayment schedule. Generally speaking, interest rates are lower when the borrower offers more collateral, assets to be taken over by the lender in the case of default. This is why the rate on home mortgages are lower than car loans which in turn are lower than the rate on personal loans. Time to maturity is an additional source of risk. Given our inability to accurately predict far into the future, anyone lending money for a long period of time will generally require a high
