Question

3. Determinants of market interest rates Aa Aa Some characteristics of the determinants of nominal interest rates are listed as follows. Identify the components (determinants) and the symbols associated with each characteristic: Characteristic Component Symbol This is the rate for a short-term riskless security when inflation Real risk-free rate is expected to be zero. TRF This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty. This is the rate for a riskless security that is exposed to changes in inflation. It is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate It is based on the bond's marketability and trading frequency: the less frequently the security is traded, the higher the premium added, thus increasing the interest rate.

Answer 1

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Real rate is defined as nominal rate + inflation rate. If expected inflation rate is zero, the real rate will be same as nominal rate. And as we are talking about risk free rate, it will be Rf. When the market anticipates higher rates of inflation, they understand that bond people will not buy them unless until they are offered higher rates as they are investing for longer periods in bonds. So company pays higher rate to compensate for rising prices, this extra premium paid by company us known as IP or inflation premium. When people buy bonds, they carry the risk if the rate of interest goes up. And it is higher as duration is increases, so to attract them to buy long term bonds, company pay them extra premium to buy long term bonds, which is known as MRP or maturity risk premium When any government issues any bond, we believe that return offered by them are 100 % safe, so