There are five components of a nominal/quoted interest rate: r=r*+IP+DRP+LP+MRP. The first component, r*, is the “real risk free rate.” This component compensates the lender for opportunity cost. To specify opportunity cost, it can be known as other opportunities the lender could have in producing growth of their investment. Since no one really knows what the real risk free rate is, one would calculate r* by taking the difference of current inflation from a 30-day government treasury bill (current). The result will make up r*. The component r* commonly makes up the sum with IP, which will make up the Nominal Risk Free Rate, (rRF) a “riskless asset” and can be found by reading the Wall Street Journal. The Nominal Risk Free Rate is the yield on a 30-day government Treasury bill.
The second component in a nominal interest rate is the inflation premium (IP). Due to how money loses value over time from excess money being printed from the Federal Reserve or by its changing value based on the rise of demand for a product of lesser supply, IP will compensate the lender for the loss in monetary value. One can find the current IP through the Government’s projected forecasts.
The Default Risk Premium is the third compensation and insures the lender from chances that the borrower will not make payment. One example of this could be that the borrower becomes unemployed and no longer has the finances to make a payment. DRP is an insurance policy that will compensate the lender for the risk of default for examples like this.
Liquidity Risk Premium (LP) is the fourth component in the nominal interest rate. It is a risk premium that compensates the lender for repayment of a loan based on the borrower’s assets. The borrower may have to use their assets in repaying loans. Highly liquid assets a firm or one may possess include cash and accounts receivables. Assets that are not very liquid include buildings, equipments, and land. If the borrower possesses many assets that are...
Please join StudyMode to read the full document