Question

Interest rates: In 350 words, discuss the importance of Inflation Premium and incorporate real examples where applicable.

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Answer 1

Interest Rates

An interest rate is either the cost of borrowing money or the reward for saving it. It is calculated as a percentage of the amount borrowed or saved.

You borrow money from banks when you take out a home mortgage. Other loans can be used for buying a car, an appliance, or paying for education.Banks borrow money from you in the form of deposits, and interest is what they pay you for the use of the money deposited. They use the money from deposits to fund loans.

Based on the relationship between supply and demand of market interest rate, there are fixed interest rate and floating interest rate. Fixed rates remain the same throughout the life of the loan. Floating interest rates also called Variable interest rate typically change based on a reference rate (a benchmark of any financial factor, such as the Consumer Price Index)

Importance of Inflation premium

Inflation premium is the portion of an investment's return that compensates for expected increases in the general price level of goods and services. The expectation of rising inflation results in higher long-term interest rates as lenders and borrowers build in an increased inflation premium.  

The primary market force causing an inflation premium is an expectation of inflation. When inflation is significant (as it has been to varying degrees since World War II), lenders know the money they will be repaid will be lower in value. They raise interest rates to compensate for the expected loss. A contributing factor is that borrowers, believing prices will rise, are more willing to pay higher interest rates to purchase goods and services on credit sooner, rather than later, when they believe prices will be higher.

Interest rates have three components. The first is the risk-free return. This is the amount of interest that lenders charge for the use of their money if there is no risk of not being repaid. The inflation premium is added to the risk-free rate to offset expected losses from the declining value of money due to inflation. The third component is the amount lenders charge to offset credit risks

Example for Inflation premium- if an investor were able to lock in a 5% interest rate for the coming year and anticipates a 2% rise in prices, he would expect to earn a real interest rate of 3%. 2% is the inflation premium. This is not a single number, as different investors have different expectations of future inflation.

An investor will derive some advantages from taking the inflation premium into account. When inflation is high, or expected to decline, look for long-term fixed rate securities to “lock in” high market rates. Conversely, If you expect inflation to rise, you will want to focus on variable-rate or short-term securities (if you are borrowing, the reverse is the case). However, predicting inflation rates is difficult, especially for long-term investments. Most financial analysts place more importance on the credit-risk component of interest rates as a primary concern.