Question

7. Determinants of market interest rates

Some characteristics of the determinants of nominal interest rates are listed as follows. Identify the components (determinants) and the symbols associated with each characteristic:

Component: Real Risk-Free Rate, Maturity Risk Premium, Inflation Premium, Nominal Risk-Free Rate, Default Risk Premium, Liquidity Risk Premium

Symbol: rRF, LP, DRP, IP, MRP, r*

Characteristic	Component	Symbol
This is the difference between the interest rate on a US Treasury bond and a corporate bond of the same profile—that is, the same maturity and marketability.
This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value.
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.
This is the premium added to the risk-free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security’s entire life.
This is the rate for a short-term riskless security when inflation is expected to be zero.

Answer 1

The correct answers are as follows:

Symbol	Component	Characteristic
DRP	Default Risk Premium	This is the difference between the interest rate on a US Treasury bond and a corporate bond of the same profile—that is, the same maturity and marketability.
LP	Liquidity Risk Premium	This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value.
MRP	Maturity Risk Premium,	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.
r*	Nominal Risk-Free Rate	This is the rate for a riskless security that is exposed to changes in inflation.
IP	Inflation Premium	This is the premium added to the risk-free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security’s entire life.
rRF	Real Risk-Free Rate	This is the rate for a short-term riskless security when inflation is expected to be zero.