Interest Rates and and their 5 Components

1.Real Risk Free Rate (r*)
The real risk free rate is the theoretical rate of return of an investment, assuming no inflation and no uncertainty about future flows like a Treasury Bill (T-Bill) rate.
Real risk-free rate = Free of inflation, default, liquidity, etc.

2.Expected Inflation (Inflation Premium = IP)
Expected Inflation is the rising price of goods and services, represents the forecasted level of the next period's inflation.
Inflation makes currency less valuable and significantly erodes purchasing power over time. That’s why nominal rate of return is increased to cover the eroding effect of inflation plus the real return for deferring consumption.
To calculate real interest rate, subtract the inflation rate from the nominal rate.
Nominal rate = real rate + inflation rate
3.Default Risk Premium (DRP)
Default risk premium is the required additional return to cover the risk of credit losses and not being repaid, related to the risk of private or public borrowers, and even to city and state governments.
Example :
Low risk : U.S. Government (strong ability to meet financial obligations)
High risk : New Start-up Companies

4.Liquidity Premium (LP)
Liquidity premium is the required additional return to cover the risk of losing money by selling assets of uncertain value in an illiquid market.

5.Maturity Risk Premium (MRP)
Maturity risk premium is the required additional return to cover the added risks associated with long-term commitments, because long-term investment carries a higher risk of default during the duration.
In other words, this premium is given to investors who have had to wait longer than usual.

Determinants of interest rates:
r = r* + IP + DRP + LP + MRP
r   = required return, represents any nominal rate
r* = real risk-free rate of interest
IP = inflation premium (eroding effect of inflation)
DRP= default risk premium (creditworthiness)
LP = liquidity premium (illiquidity)
MRP= maturity risk premium (time)

Tags: ,


Our mission is to stimulate creativity and help people learn in a very simple, clear, easy to understand way. You can find us on Facebook , Twitter , YouTube and Google+ .


Leave a Reply