Quantitative Methods - The Five Components Of Interest Rates
CFA Institute's LOS 5.a requires an understanding of the components of interest rates from an economic (i.e. non-quantitative) perspective. In this exercise, think of the total interest rate as a sum of five smaller parts, with each part determined by its own set of factors.
- Real Risk-Free Rate - This assumes no risk or uncertainty, simply reflecting differences in timing: the preference to spend now/pay back later versus lend now/collect later.
- Expected Inflation - The market expects aggregate prices to rise, and the currency's purchasing power is reduced by a rate known as the inflation rate. Inflation makes real dollars less valuable in the future and is factored into determining the nominal interest rate (from the economics material: nominal rate = real rate + inflation rate).
- Default-Risk Premium - What is the chance that the borrower won't make payments on time, or will be unable to pay what is owed? This component will be high or low depending on the creditworthiness of the person or entity involved.
- Liquidity Premium- Some investments are highly liquid, meaning they are easily exchanged for cash (U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must compensate the holder by offering a higher interest rate.
- Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to maturity it is.