Components Of Interest Rates

Quantitative Methods

    Components Of Interest Rates

  • 1. The Real Risk-Free Interest Rate

     This is the rate to which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation.

    2.An Inflation Premium

    Return on an investment over its normal rate of return. Investors seek this premium to compensate for the erosion in the value of their capital due to inflation.The inflation premium required for a one year corporate bond might be a lot lower than a thirty year corporate bond by the same company because investors think that inflation will be low over the short-run, but pick up in the future as a result of the trade and budget deficits of years past.

    3.A Liquidity Premium

    A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.

    4. Default Risk Premium

    "Default risk premium" is the added fee that a lender receives for the perceived chance that the borrower will not pay back the loan. This is seen mainly in the bond market, where firms with a greater chance of default pay more interest on a bond than safer, more stable companies pay. This can be compared to a mortgage loan, on which a bank charges higher interest to a customer with a worse credit history.

    5.Maturity Premium

    The further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium. Here’s a very simplified version to illustrate the concept: Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest in the mail. Thirty years in the future, you will get your original $10,000 back. Now, if you were going to sell your bond the next day, you would likely get around the same amount

    Consider if interest rates rise to 9%. No investor is going to accept your bond, which is yielding only 7%, when they could easily go to the open market and buy a new bond that yields 9%. So, they will only pay a lower price than your bond is worth – not the full $10,000 – so that the yield is 9% (say, maybe $7,775.) This is why bonds with longer maturities are subject to much greater risk of capital gains or losses. Had interests rates fallen, the bond holder would have been able to sell his or her position for much more – say rates fell to 5% then he could have sold for $14,000. Again, this is a very simplified version of how it would be done and there is actually a good deal of algebra involved but the results are roughly the same.

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