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CFA Level 1 - Time Value Of Money - Interest Rates
II. Interest Rates

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.
  1. 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.
  2. 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).
  3. 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.
  4. 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.
  5. Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate fluctuations the longer to maturity it is.

Next: CFA Level 1 - Time Value Of Money - Calculations

Table of Contents
1) CFA Level 1 - Chapter 2: Quantitative Methods
2) CFA Level 1 - Time Value Of Money Basics
3) CFA Level 1 - Time Value Of Money - Interest Rates
4) CFA Level 1 - Time Value Of Money - Calculations
5) CFA Level 1 - Time Value Of Money - Applications Of Calculations
6) CFA Level 1 - Discounted Cash Flow Applications - Basics
7) CFA Level 1 - Discounted Cash Flow Applications - Money Vs. Time-Weighted Return
8) CFA Level 1 - Discounted Cash Flow Applications - Calculating Yield
9) CFA Level 1 - Statistical Concepts And Market Returns - Basics
10) CFA Level 1 - Statistical Concepts And Market Returns - Basic Calculations
11) CFA Level 1 - Statistical Concepts And Market Returns - Standard Deviation And Variance
12) CFA Level 1 - Statistical Concepts And Market Returns - Skew And Kurtosis
13) CFA Level 1 - Probability Concepts - Basics
14) CFA Level 1 - Probability Concepts - Joint Probability
15) CFA Level 1 - Advanced Probability Concepts
16) CFA Level 1 - Common Probability Distributions - Basics
17) CFA Level 1 - Common Probability Distributions - Calculations
18) CFA Level 1 - Common Probability Distributions - Properties
19) CFA Level 1 - Common Probability Distributions - Confidence Intervals
20) CFA Level 1 - Common Probability Distributions - Discrete and Continuous Compounding
21) CFA Level 1 - Sampling and Estimation
22) CFA Level 1 - Sampling Considerations
23) CFA Level 1 - Confidence Intervals - Calculations
24) CFA Level 1 - Hypothesis Testing
25) CFA Level 1 - Test Statistics and Interpreting Results
26) CFA Level 1 - Correlation and Regression
27) CFA Level 1 - Regression Analysis
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