What factors affect nominal interest rates? In other words, what is the risk free rate and...

What factors affect nominal interest rates? In other words, what is the risk free rate and what factors determine the risk premium? Explain them.

Expert Solution

Answer:

The risk-free rate refers to the interest rate( or rate of return) that an investor expects from a completely risk free investment over a specified period of time.

Factors Determining the Risk-Premium:

Risk -Aversion: Risk -Aversion refers to the tendency of the investors to avoid risks that are unnecessary in nature.Higher the risk aversion of the investors higher will be the risk premium ( as this is the amount required by the investors for undertaking the additional risks) and vice-versa.

Risks associated with the Economy: Lower the risks associated with an economy lower will be the risk premium and vice-versa.

Government Polices and Regulations:Any changes in government policy or regulation which can lead to an increase in the risks associated with an increase in the risks of the economy which in turn will lead to a rise in risk premium and vice-versa.

Liquidity:The term liquidity refers to the ease of converting an investment into cash.Lower the liquidity higher will be the risk premium and vice-versa.

Any catastrophic risk: Any other catastrophic risk or chances of it will lead to a higher risk premium and vice-versa.

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