Question

How is the inflation premium and risk premiums determined? I understand that the liquidity risk and maturity risk make up the risk premium, but how are these things determined, and who decides them?  

Answer 1

Inflation is calculated by economists, who measure the change in prices of a particular set of goods over time. In the US, the Inflation rate is calculated from the Consumer Price Index (CPI-U) which is compiled by the U.S. Bureau of Labor Statistics.

There is a base year which is used as a reference point to measure inflation in the subsequent years.

Risk premiums are determined based on the risk free rate that one can obtain, generally considered to be the rate offered by 10 year US treasury bills. It is considered to be risk free because the US economy is in theory, too big to fail, and the US dollar is the primary currency used for international transactions.

Again, economists and statisticians determine how risky an asset is, and assign numeric values to their assumptions.The difference between what they expect an asset will return and the risk free rate is the risk premium.

The CAPM formula was amended over time, and things like liquidity risk and maturity risk were added to it in order to make it more practical to use. There are various rating agencies like S&P, Moody's who have entire teams of people dedicated to rating bonds and various types of securities like stocks or other derivatives like swaps, options and futures. These ratings are considered to be sacrosanct, but they, too are prone to errors based on their own biases.