Question

Explain the following briefly with your own words. (max 200 words for each.)

Assume as if you are explaning the matter to one of your colleagues who did not take acc. & finance course.

• 3) What are the determinants(components) of interest rates for bond issues?

Answer 1

3) The determinants (components) of interest rates for bond issues are as follows:-

1. Rate of Inflation ( In layman's terms - General Price Level ):

When actual or expectations about future Rate of Inflation or General Price Level increases then, the interest rate will increases. Similarly, when actual or expectations about future Rate of Inflation or General Price Level decreases then, the interest rate will decreases. This is because when, actual or expectations about future Rate of Inflation increases, there will be lower demand for bond due to low purchasing power. when demand for bond decreases, interest rate increases. Similarly, vise-versa will also hold.

2. Default risk premium (In layman's terms - comparing interest paid on a bond with government bonds) :

The another important determinants(components) of interest rates for bond issues is Default risk premium. It is the difference between a interest rate on a particular bond is compared with interest rate on same kind of government bond. If Default risk premium increases, then interest will also increases and similarly, if Default risk premium decreases, then interest will also decreases.

3. Liquidity risk:

If Liquidity risk increases then, there will lower demand for bond. When demand for bond decreases, the price of of bond decline and  interest rate increases. Similarly, If Liquidity risk decreases then, there will more demand for bond. When demand for bond increases, the price of of bond increase and  interest rate declines.

4. Real interest rate:

It means return on a bond when there is no actual or expectations about future Rate of Inflation or General Price Level to increase. It is also considered as a important, determinants(components) of interest rates for bond issues.