3. Determinants of market interest rates Aa Aa (determinants) and the symbols as

Question

3. Determinants of market interest rates Aa Aa (determinants) and the symbols associated with each characteristic: Characteristic Component Symbol This is the rate for a short-term riskless security when inflation is expected to be zero. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty. This is the difference between the interest rate on a U.S. Treasury bond and a corporate bond of the same profile-that is, the same maturity and marketability. Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium. It is based on the bond's marketability and trading frequency; the less frequently the security is traded, the higher the premium added, thus increasing the interest rate. It is calculated by adding the inflation premium to r*

Explanation / Answer

Let us first look at the market interest rate equation. According to market interest rate equation,

Required return = Real risk free rate + Inflation fremium + Default Risk premium + Maturity Risk premium + Liquidity premium

Symbolically, it is represented as:

Required return = r* + IP + DRP + MRP + LP

Answer:

1. Real risk free rate (r*) - This is a rate for a short tem riskless security when inflation is expected to be zero.

2. Maturity Risk Premium (MPR) - As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rates are unceratin, this is added as a compensation for this uncertainty. (This is higher for securities with longer term to maturity)

3. Default Risk Premium (DRP) - This is the difference between interest rate on a US Treasury bond and a corporate bond of the same profile - that is, same maturity and marketability. (This generally accounts for probability of default, higher default probability or lower credit rating demand higher premium)

4. Inflation Premium (IP) - Over the past several years,Germany, Japan, and Switzerland have had lower interest rates than the US due to lower values of this premium.(Germany, japan and Switzerland have been facing deflation since past several years)

5. Liquidity Premium (LP) - It is based on bond's marketability and trading frequency; the less frequently security is traded, the higher the premium added, thus increasing the interest rate.

6. Nominal risk free rate (rRF) - It is calculated by adding the inflation premium to r*.

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