Question

Explain the meaning of the term pure or risk-free rate of interest? Why is this interest rate important and what is its relationship to other interest rates in the money and capital markets?

Answer 1

Risk free internet rate means that getting a return on an investment without any loss for a particular period. Hence it is a risk free return we can say. If investment have any risk involved than investors ask for more return for bearing that risk.

This interest rate is important because based on this lenders and borrower come together and exchange money for their respective purposes i.e. borrower needs money for their current consumption ( loan, investment for project, car, education etc.) as well lenders want to have return on their money by giving it to borrower as their current need. This rate is set by central bank based on the equilibrium between borrower and lenders i.e. they decide rate at which borrower agree to take and lenders agree to give money.

Interest rate are very much important as they are connected with the economy of the country. It effects consumer spending, housing market, foreign investment, inflation, infra development etc. Higher rate increase borrowing cost which reduces consumption and vice versa.

Now risk free interest rate have following relationship with other rates in money and capital markets.

Main difference between money market rate and capital market rate is that money market is for short term hence here inflation factor will not be much effective considering lower duration / maturity which will not change inflation and premium for that whereas due to inflation uncertainty capital interest rates are a bit higher.

As Nominal interest rate = real component + inflation component.

Thanks!!