Interest Rates - YouTube

>> A simple way of thinking about a rate for a security is

that it is the risk free rate earned on a risk free security,

like a three month treasury bill,

plus compensation for various risk factors that the risk-free security doesn't have.

We call this compensation risk premiums.

We can determine the nominal rate of interest,

also called the quoted rate or the real rate with the following formula.

Real risk-free interest rate, plus inflation premium,

plus default risk premium,

plus maturity risk premium,

plus liquidity risk premium.

Real risk-free interest rate is

the interest rate on a fixed income security that has no risk.

Usually, the three month treasury bill or a bank certificate of

deposit that is maturing soon are

common examples of a fixed income security with no risk.

The real risk-free interest is

the risk-free interest on that fixed income security minus the inflation premium.

The inflation premium is a premium to

compensate for anticipated inflation over the life of the security.

The default risk premium is a premium to

compensate for the risk that the firm will default.

Meaning, declare bankruptcy.

This amount is the difference between

a US Treasury Bond interest rates and

a corporate bonds interest rates with the same maturity and marketability.

The maturity risk premium is a premium to compensate for

the greater risk of price fluctuations caused by interest rate changes.

This premium is larger when maturity is along way away.

Often, it is the difference between

the 30-year treasury bond and the three month treasury bill.

The liquidity premium is a premium to compensate for

greater risk of not being able to quickly convert securities into cash.

Okay, let's look at an example.

You can see the various rates across the top.

Let's calculate the nominal rate of interest.

The real risk-free rate is the three-month treasury bill minus the inflation rate.

This equals 1.29 percent.

Then we add the inflation premium of 3.6 percent.

Then we add the default risk premium,

which is the difference between the 30-year corporate bond and the 30-year treasury bond.

This amount is 0.86 percent.

Then we add the maturity risk premium,

which is the difference between

the 30-year treasury bond and the three-month treasury bill,

this amount is 0.49 percent.

Finally, we add the liquidity risk premium,

which is given at three percent.

We add all of those up and get a nominal rate of interests of 6.27 percent.

Make sure you can solve something

because you're going to see something similar in the homework.