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04model 10/6/2009 8:16 12/2/2002 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 internet. 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 to exist. 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 projections. 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 liquidity. 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. Lastly, 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. That is, 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.
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This note was uploaded on 05/31/2009 for the course MBA 4500 taught by Professor Eyupcetin during the Spring '09 term at Istanbul Technical University.

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