Question

Explain the possible determinants of the market interest rate that you chose. For example, you should explain how the inflation rate in the economy could be expected to impact the market rate that you chose.

Answer 1

Determinants of Markets Interest rate risk are as follows:

Market interest rate = Risk free rate + inflation risk premium + default risk premium + liquidity risk premium and maturity risk premium

Market Interest rate comprise of risk free rate, it is a rate which is offered on treasury bills and this is called risk free rate at which rate of risk is zero so this is the minimum guaranteed return which is expected on Investment. Apart from the risk free rate, another element is inflation risk premium, this is the premium that arises due to change in inflation in the economy. Due to inflation the purchasing power of investment gets reduce and as a results inflation premium is charged. Another element of market interest rate is liquidity risk premium, this arises due to risk associated with the liquidity or marketability of the security. Another element is default risk premium, this portion of market rate of interest arises due to the chances of default of principal and interest on securities.

Last element of market interest risk is maturity risk premium, this arises from the maturity period of the security a security with longer maturity premium would be higher in comparison of shorter maturity security