Lesson 1 of 8 · 13 min

What an interest rate is made of

An interest rate prices the gap between money now and money later, and it is built from a real risk-free rate plus a premium for each risk the lender carries.

In short

  • An interest rate links cash flows on different dates. It can be read as a required rate of return, a discount rate or an opportunity cost.
  • Build-up: real risk-free rate + inflation premium + default risk premium + liquidity premium + maturity premium.
  • Real risk-free rate + inflation premium = nominal risk-free rate, proxied by short-term government bills. Exact link: (1+rnom)=(1+rreal)(1+Ï€)(1+r_{\text{nom}}) = (1+r_{\text{real}})(1+\pi); in practice the sum is used.
  • Isolate a premium by comparing two securities that differ in only one feature.
  • Quoted rates are annual, even on a 90-day bill.

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What an interest rate is made of · Rates and Returns