INTEREST RATES (I need help explaining the following and/or demonstrating it for

Question

INTEREST RATES

(I need help explaining the following and/or demonstrating it for my upcoming exam if anyone could help me comprehend the concepts I would greatly appreciate it!!)

Explain what interest rates are and what causes them to change..

Explain the difference between nominal and real interest rates..

Calculate the difference between the risk free rate of return (r*) and the risk free security (rRF)..

Explain how and why U.S. Treasuries act as proxies for the risk free security..

Interpret the inflation premium, default risk premium, maturity risk premium, and liquidity premium..

Calculate a nominal interest rate given the risk free rate of return (r*) and all necessary premiums..

Interpret and explain the term structure of interest rates (yield curve)..

Use the yield curve to make inferences about the future direction of interest rates..

Use the yield curve to compare and contrast bonds of different types and interpret yield spreads..

Calculate a future interest rate given spot interest rates, using the Pure Expectations Theory..

Explain how the Federal Reserve impacts interest rates..

Explanation / Answer

1.   Explain what interest rates are and what causes them to change..

Answer: Interest Rates are the cost of capital, which we pay for our borrowings and receive for deposits (money) over a period of time.

Reasons for change - interest rates change as per changing macroeconomic conditions, liquidity, inflation and economic factors of demand and supply of cash in the system.

2.   Explain the difference between nominal and real interest rates..

Answer: Nominal Interest Rates do not take inflation into account. These are the rates quoted on bonds, fixed deposits and loans. If you deposit $ 1000 at 5% interest rate into fixed deposit scheme, you get $50 of interest irrespective of the inflation.

Real interest rate takes inflation into account. Real interest rate is calculated by subtracting the expected or actual inflation rate from nominal interest rate. Real interest rate gives a better idea if there’s an increase in purchasing power or not. If the real interest rate is positive, that means increase in purchasing power. Taking the same example as above, if the inflation rate is 4%, then the real increase in purchasing power is 1%

3.   Calculate the difference between the risk free rate of return (r*) and the risk free security (rRF).

Answer: Risk free rate of return is the theoretical rate of return on an investment with zero risk of losing money over a specified period of time. It is the minimum return expected by an investor for his/her investment without taking an additional risk.

Risk free security – any security (usually long term bonds) issued by the government are considered risk free security.

4.   Explain how and why U.S. Treasuries act as proxies for the risk free security.

Answer: US Treasuries act as proxies for risk free security, as they are backed by government. Since US Treasuries control the printing of currency, so in nominal terms, they should be able to fulfil their promises.

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