Components of Market Interest Rates
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
Interest Rate Calculations
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.