3. What are the components of interest rate? How does a credit institution manage its interest...

3. What are the components of interest rate? How does a credit institution manage
its interest rate risk? You need to explain with proper terms.

Expert Solution

Component of interest rates are as follows-

A. Real interest rates are those interest rates which will reflect the risk free rate of interest without any effect of inflation. It will be reflecting the preference of various individual on current consumption versus future consumption.

B. Inflation premium will be reflecting the rate of inflation which is prevalent in the economy and it will be included in the overall interest rate

C. maturity risk premium is another component which will reflect that investors will be demanding a higher rate of interest for investing into securities with higher maturities

D. Default risk premium is another component of interest which will be reflecting that borrower will fail to make the interest payment on debt.

E. Liquidity premium will be another component of interest rate which will reflect that there will be a premium for those debt instrument who are more liquid and short term debt instrument are more liquid.

Credit institutions will be managing interest rate risk by taking various exposes by maintenance of the bond portfolio and non deposit funding and it will be also trying to take exposure into the derivative securities and there are interest rate swaps which will be swapping the the stream of payment of fixed interest rate with floating interest rate and they will be leading to lowering the risk related to fluctuation in the interest rate.

jeff jeffy answered 1 year ago

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