This module is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.
Lesson 2 of 9 · 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: ; 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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