Hello and welcome back.
In the previous blog, we talked about the 3 ways in which Interest rates can be interpreted which was the first learning outcome for this reading. If you haven’t read the previous blog, please read it first.
In this blog, we will talk about the various components of interest rate. Let’s take an example, suppose you have 1000$ to invest and you have two options: the first one is to invest it in U.S. Treasury bills or T-bills, the 2nd option is to loan it to an entrepreneur who is starting a new venture. Do you expect both these investment options to have the same rate of return?
Of course not as these two investment options have different “risks” associated with them. And any sensible investor would want a higher return for a riskier investment. So, it’s clear that interest rate varies.
Now, let’s look at the various components of an interest rate:-
Let’s try and understand each of these components.
1. Real risk-free rate: The real risk-free rate is a theoretical rate that a completely risk-free investment would provide in a single period, if there was no inflation. So, the real risk-free rate basically provides the rates at which a completely risk-free investment would grow in a period, if there was no inflation.
The closest real world example to this would be U.S. Treasury bills or T-bills, if we could remove the component of interest rate that compensates for inflation (or the inflation premium, which is discussed next).
2. Inflation Premium: The inflation premium is the premium for expected inflation over the duration of the investment. The key word here is expected. Obviously, the inflation is not zero; you do expect the cost of most things to go up with time and you don’t want your purchasing power to decrease over the period of investment. The inflation premium is supposed to ensure that your purchasing power stays the same. Now, we cannot predict the actual inflation, so expected inflation premium is used.
Next, let’s talk about the Nominal risk-free interest rate. While the real risk-free rate is a theoretical concept, nominal risk-free rate (which is the sum of real risk-free rate and inflation premium) is a real concept. U.S. Treasury bills or T-bills are considered to be representative of Nominal risk-free rate.
This is why when we discussed Real risk-free interest rate, we mentioned that if you could take out the inflation component from U.S. Treasury bills, you would get the real risk-free interest rate.
Please note that the above relation is an approximate relation. The actual relation is:-
3. Default Risk Premium: As we were discussing before, you don’t expect an investment with an entrepreneur to have the same level of risk as U.S Treasury bill. There is a possibility that the entrepreneur may not be able to return you the promised amount of money at the agreed upon time. There is a risk that the business might not do as well as expected or worse, it completely fails and you do not get your money back. This is a risk that you are taking when investing money with the entrepreneur and you would want a premium, an interest rate differential for taking this risk. This premium is called the Default Risk Premium.
As you can expect, this risk will vary by the investment (riskiness of the project) as well as the credit worthiness of the borrower.
4. Liquidity Premium: Liquidity premium compensates for the potential risk of losing money if the investor needs to get cash urgently. So, if there are a lot of investors and buyers for a specific investment, the liquidity premium will be low. However, if not a lot of investors and buyers are interested in a specific investment, the liquidity premium will be high.
Suppose you need cash urgently and you have invested your 1000$ in U.S. Treasury Bills, you can easily sell these. However, if you are trying to sell your position with the entrepreneur chances are that you won’t have the same number of interested investors. There is a possibility that you won’t be able to sell your position in the entrepreneur’s business at a fair value. The liquidity premium is supposed to offset not only the cost associated with selling an investment, but also the loss because of not receiving a fair price.
5. Maturity Premium: Maturity premium compensates for the potential of interest rates to change during the life of an investment. Let’s say you have decided to invest your 1000$ in a particular investment and the only decision you have to make is if you want to invest for 1 year or 5 years. Will you expect to get the same interest rate?
Of course not!
When you invest money for 5 years at a fixed rate, you cannot change the interest rate for 5 years! What if the market rate for the investment goes up in this time period? Even if your interest rate is tied to a reference rate like LIBOR (i.e. you are earning a certain % more than the prevailing LIBOR per period), you still cannot change the spread (i.e. the percent above LIBOR you are earning).
For example, let’s say you have made an investment in a security at LIBOR+ 1%. This means you will be earning 1% higher than the LIBOR every period. So, if the LIBOR rises up, your earnings increase and vice versa. However, as you have fixed your spread at 1% above the LIBOR, your earnings will always be 1% more than LIBOR. As a result, you won’t be able to change the interest rate even if the existing market rate for that security goes up.
Maturity premium compensates for these uncertainties over the investment horizon.
You can watch a video explaining the points discussed in this blog here:-
This brings us to the end of learning outcome b for this reading. In the next blog, we will talk about learning outcome c: How to calculate effective annual rate.
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