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a)
What are the four most fundamental factors that affect the cost of money, or the general level of interest
rates, in the economy?
1) Production Opportunities – This relates to the opportunities available for investment in productive assets
2) Time preference for consumption – This relates to the preference for current consumption or for future
consumption
3) Risk – Risk implies that there is a possibility that the investment may produce a lower or negative return
4) Inflation – The rate of increase in prices over time
b) What is the real riskfree rate of interest (r*) and the nominalfree rate (r
RF
)? How are these two rates
measured?
1) Real risk free rate refers to the rate on default risk free securities if there was no inflation. The nominal
risk free rate incorporates inflation and so real risk free rate + inflation
2) The nominal risk free rate is the yield on short term government securities since these would be default
risk free. The real risk free rate is measured by subtracting the inflation rate from the nominal risk free
rate.
c)
Define the terms
inflation premium (IP), default risk premium (DRP), liquidity premium (LP),
and
maturity
risk premium (MRP).
Which of these premiums is included in determining the interest rate on (1) shortterm
U.S. Treasury securities, (2) longterm U.S. Treasury securities, (3) shortterm corporate securities, and (4)
longterm corporate securities? Explain how the premiums would vary over time and among the different
securities listed.
1) IP is the inflation premium and is the premium added to the real risk free rate to compensate for
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This note was uploaded on 05/22/2010 for the course FINC 520 taught by Professor Miller during the Spring '10 term at Davenport.
 Spring '10
 MILLER
 Interest, Interest Rate

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