Determinants of Interest Rates: Inflation, Risk, and Liquidity
Explore the factors that determine interest rates for Exam FM.
Components of Interest Rates
The nominal interest rate can be decomposed into components: the real risk-free rate, an inflation premium, a default risk premium, a liquidity premium, and a maturity risk premium. The real risk-free rate compensates for the time value of money in the absence of inflation and risk. Each additional component compensates the lender for a specific type of risk.
The Fisher equation relates nominal and real rates: (1 + nominal) = (1 + real)(1 + inflation). For small rates, the approximation nominal is approximately equal to real + inflation is commonly used.
Inflation and Real Returns
Inflation erodes purchasing power. The real rate of return is r = (i - pi)/(1 + pi), where i is the nominal rate and pi is the inflation rate. For Exam FM, you may be asked to compute the real return on an investment or to compare nominal and real annuity values. When payments are fixed in nominal terms, their real value decreases with inflation. Inflation-indexed payments maintain purchasing power.
Risk and Liquidity Premiums
Default risk premium compensates for the possibility that the borrower may not repay. Higher-risk borrowers pay higher rates. The liquidity premium compensates for difficulty in selling the asset quickly at fair value. Less liquid investments require higher returns. The maturity premium compensates for the greater interest rate risk of longer-term bonds. These premiums explain why the yield curve is typically upward-sloping. Exam FM tests these concepts qualitatively rather than quantitatively.