Interest Rates

Market Interest Rates

Components of Market Interest Rates

The interest rate for the return on market investments is dependent on maturity term and risk.

The interest rate is affected by many components of the financial system. It is a variable rate and is the amount due per period as a percentage of the amount owed at the end of the previous period. The market interest rate is simply dependent upon the supply of credit and a demand for credit in the marketplace. The market segmentation theory allows for some distinction between interest rates. Market segmentation theory is the belief that long-term and short-term interest rates are separate and not associated with each other, as both are controlled by differing factors. Inflation, which would affect long-term decision-making, would not be the same when looking at short-term-maturation securities.

Within the basic market interest rate is another component, called inflation. Inflation is the continual increase in the average price levels of goods and services. Various forms of inflation exist that further affect interest rates in different ways. Cost-push inflation is a situation that occurs when increased production costs, such as for raw materials and labor, cause elevated price levels. Because this type of inflation is linked to manufacturing costs, it can change rapidly. Natural disasters or powerful labor unions can also alter the cost of production. The more widely known form of inflation is demand-pull inflation. With demand-pull inflation an increase in consumer demand for a product or service causes increased price levels. As overall demand for products outstrips supply, prices go up. It is more difficult to predict speculative inflation, which occurs when people believe prices will continue to rise and they purchase more now to minimize losses and maximize gains. If politicians place restrictions on the export of raw materials, it will lead to an increase in material prices and create cost-push inflation. If the banks attempt to adjust interest rates in anticipation of import/export regulations, it will cause speculative inflation. These various forms of inflation can affect the inflation premium, which is an increase in the normal rate of return to investors to compensate for anticipated inflation. For a bond security to be attractive to investors, its return must be greater than the inflation-adjusted minimally required return.

With all of the inflation components affecting interest rates, a thorough investor should know the potential inflation responses and the causes of inflation. This knowledge will help the investor make informed decisions. Investors may also consider the liquidity preference theory to ensure their financial interests are addressed. Liquidity preference theory is a belief that investors require a higher premium on medium- and long-term investments versus short-term investments to offset investors' desire for greater liquidity.

Treasury Securities as a Baseline

Risk-free rates from Treasury securities are used as the baseline of commercial securities that have risk.
A U.S. Treasury security is considered risk free, as is a Treasury bill, bond, or note issued by the U.S. Treasury. Treasury securities rates are used as the baseline for the calculations of commercial securities that have risks. The risk-free interest rate is the expected rate of return with no risks or financial losses, often estimated from U.S. bonds and treasuries. The risk-free interest rate is a composite of the real rate of interest and a premium for inflation. The idea may sound definite, but investors have found that accepting this without consideration is ineffective and fiscally counterproductive. Though the risk is small, Treasury bonds do have some risk of default. Greece has defaulted on its bond payments previously. Likewise, bond volatility is possible if bonds are traded too aggressively. In short, the risk-free rate of return is not actually free from risk. Investors calculate the real rate of return as the real risk-free rate differs from the stated risk-free rate. There is a formula for the risk-free rate.
Risk-Free Interest Rate=Real Rate of Interest+Inflation Premium\text{Risk-Free Interest Rate}=\text{Real Rate of Interest}+\text{Inflation Premium}
If the Treasury security is paying the risk-free interest rate, then the risk here is inflation. Removing the inflation premium by subtracting it from both sides results in a different formula.
Real Rate of Interest=Risk-Free Interest RateInflation Premium\text{Real Rate of Interest}=\text{Risk-Free Interest Rate}-\text{Inflation Premium}
The real rate of interest is an adjusted interest rate to remove inflation to indicate the real cost of an investment. Real rate of interest is the return with no calculable risk. As an example, if the Treasury security has a return of 3 percent and the current inflation is 2 percent, the real rate of interest with no associated risks is 1 percent. This is an important factor when making decisions against equity investments. The cost of capital when issuing bonds is a function of the risk-free rate and the market rate. The weighted difference between the two rates will dictate the overall cost of building capital for the company. If the risk-free rate improperly calculates the effects of inflation, the total cost of creating the capital can become greater than the actual capital generated, resulting in a loss. If Cogs Inc. were raising capital with a cost of capital rate of 7 percent, the real rate of interest must beat this rate. If inflation is erroneously calculated, then the real rate will be incorrect. If it drops under 7 percent, any money that Cogs Inc. generated as capital would be a net loss. If the real rate of interest is 5 percent and the inflation premium is 2 percent, for example, the risk-free interest rate is 7 percent.

Interest Rate Calculations

The observed market interest rate can be calculated.
The market interest rate is the rate of interest that a free market can bear. It is dependent on the types of risk associated with the underlying asset. If inflation is the only risk, then the market rate is called the risk-free interest rate. The risk-free interest rate is the expected rate of return with no risks or financial losses. Inflation is the only risk factor associated with this type of security.
Risk-Free Interest Rate=Real Rate of Interest+Inflation Premium\text{Risk-Free Interest Rate}=\text{Real Rate of Interest}+\text{Inflation Premium}
Treasury bonds are generally used as a rate factor for commercial bonds that have a risk of defaulting. For bonds at risk of default, a default risk premium is added to the risk-free rate. A default risk premium is a fee that a borrower is charged to compensate for the possibility that the borrower might default on the loan.
Market Interest Rate=Real Rate of Interest+Inflation Premium+Default Premium\text{Market Interest Rate}=\text{Real Rate of Interest}+\text{Inflation Premium}+\text{Default Premium}
If the risk-free interest rate is 7 percent and the default risk premium is 1 percent, then the market interest rate is 8 percent.

Some securities have exceptionally long maturity dates. A lot can change in the course of many years or, in some cases, several decades. The market rates can fluctuate significantly over such a long period. To compensate for this form of risk, a maturity risk premium may be included. Maturity risk premium is the extra premium an investor receives for engaging with investments that have a longer duration until maturity. Similarly, some securities are difficult to trade, making their liquidity low. Compare cashing a check, which is a very liquid asset, to selling a house; it could take a year before the cash from selling a house is available to deposit into a bank. To compensate for this form of risk, a liquidity premium is attached. Liquidity premium is an additional financial return expected by investors to offset assets not easily converted to cash.

In cases where maturity and liquidity may include a risk, the maturity risk premium and the liquidity premium are added to the equation.
Market Interest Rate=Real Rate of Interest+Inflation Premium+Default Premium+Maturity Risk Premium+Liquidity Premium\begin{aligned}\text{Market Interest Rate}&=\text{Real Rate of Interest}+\text{Inflation Premium}\\&+\text{Default Premium}+\text{Maturity Risk Premium}+\text{Liquidity Premium}\end{aligned}
With a real rate of interest of 3 percent, an inflation premium of 1 percent, a default premium of 1 percent, a maturity risk premium of 2 percent, and a liquidity premium of 1 percent, the market interest rate is 8 percent.