Composition of Interest Rates

Interest rates are set in the marketplace by the forces of supply and demand.

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.

Nominal risk-free interest rate (approximately)

= real risk-free interest rate +  inflation premium

eg. US Treasury bill (T-bill)

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 as maturity is extended, in general (holding all else equal).

[Practice Problems] Which of the following risk premiums is most relevant in explaining the difference in yields between 30-year bonds issued by the US Treasury and 30-year bonds issued by a small private issuer?

A.       Inflation

B.        Maturity

C.        Liquidity

[Solutions] C

US Treasury bonds are highly liquid, whereas the bonds of small issuers trade infrequently and the interest rate includes a liquidity premium.

This liquidity premium reflects the relatively high costs (including the impact on price) of selling a position.