Chapter 4. Model for analyzing the financial environment
THE DETERMINANTS OF INTEREST RATES
Interest rates can easily be observed.
All it requires is reading the newspaper, watching television, or surfing the
However, it is not so easy to see the factors that determine market interest rates, and the extent to which they
shape interest rates.
Naturally, the determination of interest rates is a macroeconomic question that has numerous
contributing factors. However, in an effort to simplify the composition of interest rates, we will look at nominal
interest rates being composed of five driving forces, as outlined here:
Nominal interest rate = k
= k* + IP + DRP + LP + MRP
Here k* represents the real risk-free rate of interest, IP is the inflation premium, DRP is the default risk premium, LP
is the liquidity premium, and MRP is the maturity risk premium.
Together, these five factors determine the nominal
interest rate, denoted by k.
k*, or the real risk-free rate, can be defined as the rate of return to be expected on a riskless security if no inflation were
The closest estimator to k* in the U.S. market would be indexed Treasury bonds.
While k* may vary over time,
it is reasonable to assume a constant real risk-free rate in the short-term.
Moreover, we would conclude that k* is a
universal parameter for all securities, at a given point in time.
The inflation premium is the average expected rate of
inflation over the life of the security in question.
Thus, the inflation premium can be inferred from future inflation
The default risk premium reflects the possibility that the issuer of a security will be unable to make any or
all interest or principal payments. The liquidity premium reflects the fact that investors prefer securities that offer
In other words, they prefer securities that can be quickly converted to cash or cash equivalent at full or
nearly full market price.
Naturally, a requirement for liquidity is that the security is in a high demand market.
the market risk premium reflects the fact that securities that mature in the more distant future are riskier than those
that mature in the near term.
The source of that risk arises primarily from price, or interest rate, risk.
rising interest rates will cause a longer termed security to lose value.
DISTINGUISHING THE COMPONENTS OF TREASURY AND CORPORATE BONDS
Having stated the possible risk premiums that bonds are subject to, we must now sort them out and identify which types
of securities face which kind of risk.
Short-Term Treasury securities
First, it is important to recognize that all Treasury securities are fully guaranteed by the U.S. government.
As a result
all Treasury securities are without default risk.
Since, the Treasury bond market is the largest bond class in the
market, there is also heavy daily trading in Treasury securities, resulting in no liquidity risk for Treasury securities.
Because the maturities on short-term securities are for less than a year, short-term Treasuries have no maturity risk.