An interest rate (or yield), denoted r, is a rate of return that reflects the relationship between differently dated – time – cash flows.
Interest rates can be thought of in three ways:
- required rates of return
- discount rates
- opportunity cost
Taking the perspective of investors in analysing market-determined interest rates, we can view an interest rate r as being composed of a real risk-free interest rate plus a set of premiums that are required return or compensation fro bearing distinct type of risk:
r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium
- The real risk-free interest rate is the single-period interest rate for a completely risk-free security if no inflation were expected.
- The inflation premium compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt.
- The default risk premium compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.
- The liquidity premium compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.
- The maturity premium compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates asa maturity is extended, in general (holding all else equal).
The nominal risk-free interest rate reflects the combination of a real risk-free rate plus an inflation premium:
(1 + nominal risk-free rate) = (1 + real risk-free rate)(1 + inflation premium)
In practice, the nominal rate is often approximated as the sum of the real risk-free rate plus an inflation premium:
Nominal risk-free rate = real risk-free rate + inflation premium
