Aa Aa E. 7. Determinants of market interest rates Some characteristics of the de

ID: 2383030 • Letter: A

Question

Aa Aa E. 7. Determinants of market interest rates Some characteristics of the determinants of nomina nterest rates are listed as follows. Identify the components (determinants) and the symbols associated with each characteristic: Characteristic Component It changes over time, depending on the expected rate of return on productive assets exchanged among market participants and people's time preferences for consumption. 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 As interest rates rise, bond prices fa 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 rate for a riskless security that is exposed to changes in inflation. 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. This is the premium added to the risk-free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security's entire life.

Explanation / Answer

Component

Reasons

Real Interest Rate

Real interest rate depends upon the demand for capital borrowing. When the borrowing pressure is high, rates go up. This rate is charged, because the lender is foregoing his consumption of principal amount in future. This is logical because if you have an asset from which you can benefit today but instead of taking that benefit you decide to rent it out and enjoy it at a future date, you will charge an interest for deferring your consumption. Hence real interest rate depends on preference of consumption pattern of people

Default Risk Premium

If the borrower is not creditworthy i.e. does not guarantee the repayment of principal amount, then based on the credit quality of the borrower, lender charges a premium for the default risk. Since US T Bonds are backed by full faith of US Govt, hence their default risk is zero. This is not similar for a corporate bond.

Maturity Risk Premium

When interest rate changes, the bond price also changes and there is an inverse relationship between the two. However the quantum of change in bond price depends on the maturity of the bond which is directly related to bond price i.e. for longer term maturities bond price movements are greater than shorter term maturities. Lenders will charge a premium if the borrower holds their principal for a longer duration. Hence, whenever interest rates fall, the bond prices also changes and based on the maturity of the bond, the lender charges the premium for such uncertainty.

Risk Free Rate

As the name suggests, this is the rate charged for a riskless security which does not contain risk factors such as inflation, liquidity, credit default. Such bonds trade similarly to Treasury bonds.

Liquidity Premium

Marketability of bond refers to the ease of selling conditions of a bond. If a bond is difficult to sell, then such bonds are classified as illiquid bonds I.e. it could ot be converted readily into cash. Hence, if a bond is illiquid, the lender would charge a premium depending on the liquidity.

Inflation Premium

A bond is exposed to changing levels of inflation. During inflation, the purchasing power of the lender decreases. i.e. given inflation, with a fixed amount, he will be able to buy less goods in future than he could right now. Hence to protect the lender from inflation risk, an inflation premium is charged by the lender.

The Treasury Inflation Protected Securities (TIPS) is a good hedge for inflation as every time the Infation results are decided, the coupon rate adjusts itself to include the effects of inflation.