a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
The four most fundamental factors that affect the cost of money are: production opportunities, time of consumption, risk and inflation. The interest rate given to savers is based on: the rate of return on invested capital, savers time preferences for current versus future consumption, the riskiness of the loan, the expected future rate of inflation. High inflation and high risk will result in high interest rates.
b. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured?
The real risk-free rate of interest is the rate that would exist on default-free securities when there is no inflation. The nominal risk-free rate is equal to the real risk-free rate plus an inflation premium. The inflation premium is equal to the average expected inflation rate over the life of the security into the rate they charge. These rates are measured in percentages.
c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.
Inflation premium is a premium added to the real risk-free rate of interest to compensate for potential inflation. The default risk premium is a premium based on the probability that the person who issues the loan will not follow through; this is measured with the difference between the U.S. interest rate on a Treasury bond and a corp. bond of equal maturity and marketability. A liquid asset can be sold at a...