In addition to supply-and-demand relationships, interest rates are determined by a number of specific factors or components. The market interest rate is the interest rate observed in the marketplace for a debt instrument. A market or nominal, interest rate contains at least two components—a real rate of interest and an inflation premium.
The real rate of interest is the interest rate on a risk-free financial debt instrument when no inflation is expected. It is generally believed that investors must expect a minimum level of return in order to get them to invest in debt instruments instead of holding cash.
The inflation premium is the additional expected return to compensate for anticipated inflation over the life of a debt instrument. In its simplest form, the observed market interest rate (r) can be expressed as,
r = RR + IP
where RR is the real rate of interest and IP is an inflation premium. For debt instruments that have no additional risk components, this interest rate is called the risk-free interest rate.
In practice, it is difficult to identify a debt instrument that trades in the market based only on a risk-free interest rate.
Most debt instruments will also have a default risk premium. The equation can be expanded to include expected compensation for this additional risk:
r = RR + IP + DRP
where DRP is the default risk premium.
The default risk premium is the additional expected return to compensate for the possibility that the borrower will not pay interest and/or repay principal when due according to the debt instrument’s contractual arrangements.
In essence, “higher returns are expected for taking on more risk.” This is a higher “expected” return because the issuer may default on some of the contractual returns. Of course, the actual “realized” return on a default risky debt investment could be substantially less than the expected return. At the extreme, the debt security investor could lose all of his or her investment.
Instead of a default risk premium, the concentration is on “stock risk premiums” and “market risk premiums.”
Two additional premiums are added to the equation to explain market interest rates for debt instruments with varying maturities and liquidity. This expanded version can be expressed as,
r = RR + IP + DRP + MRP + LP
where MRP is the maturity risk premium and LP is the liquidity premium on a debt instrument.
The maturity risk premium is the additional expected return to compensate for interest rate risk on debt instruments with longer maturities. Interest rate risk is the risk of changes in the price or value of fixed-rate debt instruments resulting from changes in market interest rates.
There is an inverse relationship in the marketplace between debt instrument values or prices and market interest rates. For example, if market interest rates rise from, say, 4 percent to 5 percent because of the expectation of higher inflation rates, the values of outstanding debt instruments will decline.
Furthermore, the longer the remaining life until maturity, the greater the reductions in a fixed-rate debt instrument’s value to a specific market interest rate increase.
The liquidity premium is the additional expected return to compensate for debt instruments that cannot be easily converted to cash at prices close to their estimated fair market values. For example, a corporation’s low-quality bond may be traded very infrequently.
As a consequence, a bondholder who wishes to sell tomorrow may find it difficult to sell except at a very large discount in price. Possibly, this should be called an illiquidity premium since the premium is compensation for a lack of liquidity. However, it is common practice to use the term liquidity premium.