**The Determinants of Market Interest Rates**

The market interest rate on debt securities is the real rate of interest adjusted to expected inflation plus several premiums reflected by securities’ riskiness and marketability. Thus, the determinants of market interest rates are as follows:

**The Real Risk-Free Rate of Interest**

Assuming no inflation in the economy, the cost of funds is solely determined by the interaction between the demand for loanable funds for investment and the supply of loanable funds from savings. The real risk-free rate of interest is an equilibrium rate resulting from investment in risk-free assets in an economy free from inflation. For example, the rate of interest on Treasury bills can be thought of as the real risk-free rate provided that there is no inflation in the economy. In such an economy, the real risk-free rate is determined by the interaction between demand for and supply of loanable funds for risk-free investment.

However, the real risk-free rate of interest does not remain constant. It varies over time depending on the state of the economy. One factor causing the variation in the real risk-free rate is the investor’s expected rate of return from productive investments. For example, if investors expect a high rate of return from their investments in productive assets, they increase the demand for funds. This pushes the real risk-free rate up. Similarly, a saver’s time preference toward consumption also affects the real risk-free rate. For example, if the savers have the tendency to save more for future better consumption, the supply of funds increases in the economy. This brings down the real risk-free rate. Putting it simply, the real risk-free rate of interest increases if demand increases or supply decreases, assuming no other changes. Conversely, it decreases if demand decreases or supply increases. The real risk-free rate is very difficult to measure in practice. However, we can use the rate of return on indexed Treasury bonds as the proxy of the real risk-free rate. This bond offers a certain coupon rate plus an additional rate of return that is sufficient to compensate against the effect of inflation.

**The Nominal Risk-Free Rate of Interest**

An economy with no inflation does not exist in a real situation. The nominal risk-free rate of interest (KRF) is the actual rate of interest charged by the supplier of funds and paid by the users of funds. It is the real risk-free rate of interest (k) plus the expected average inflation premium (IP) over the life of security. It is denoted as:

**KRF = k + IP**

The quoted rate of interest on all risk-free securities is the nominal risk-free rate. For example, the rate of interest on Treasury bills can be thought of as the short-term nominal risk-free rate and that on Treasury bonds as the long-term nominal risk-free rate. Treasury bills are free from default risk, maturity risk, liquidity risk, and any other risk factors. The interest rates on Treasury bills only move one-to-one with expected inflation. Inflation represents the change in price level in the economy thus it affects the purchasing power of money. The expected inflation directly affects the interest rates. For example, if a high inflation rate is expected, the supplier of funds will demand a higher rate of interest to recover the loss in purchasing power of money.

To illustrate the effect of inflation, let us assume that we have Rs 10,000 to invest in a one-year Treasury bill that pays 6 percent interest. If we invest in this security, we will realize Rs 10,600 in total at the end of the year, which includes Rs 10,000 principal plus Rs 600 in interest. But if the rate of inflation is 7 percent during the year, Rs 10,600 at the end of the year will have a lower purchase power than Rs 10,000 at the beginning of the year. Therefore, we build in an inflation premium equal to the expected inflation rate over the life of security. Note that with a 7 percent inflation rate, Rs 10,700 at the end of the year will have the same purchasing power as Rs 10,000 at the beginning of the year.

Here we are concerned with the average inflation rate expected over the holding period of security. It is not the rate of inflation experienced over the immediate past, rather it denotes the forecasted rate. For example, suppose that we expect the rate of inflation to be 8 percent next year and to fall to 7 percent during the following year, which then remains at a 4 percent level after that. The expected inflation premium over the year 1, 2, 3, and 5 is given in Table 3.1.

Year | Expected Inflation | Average Inflation Premium (IP) |

1 | 8% | 8% |

2 | 7% | (8+7)/2=7.5 |

3 | 4% | (8+7+4)/3=6.33 |

5 | 4% | (8+7+4+4+4)/5=5.4 |

However, future expected rates of inflation are more or less closely related to those rates experienced in the recent past. Therefore, if the rate of inflation experienced in the near past increased, the investor would expect the rate of inflation to rise in the future causing the interest rates also to rise.

**Default Risk Premium**

Default risk refers to the chance that the issuer of securities will not pay the contractual payments Default risk premium is the additional payment above the risk-free rate that occurs due to the chance that users of funds will not pay the contractual interest payment and principal repayment. The higher the uncertainty that the issuer of securities makes timely payment of interest and repayment of principal at maturity, the higher will be the default risk premium. If an investor is uncertain about the receipt of regular interest income and principal at maturity, s/he expects a higher default risk premium so that the market interest rate rises. Government securities are free from default risk because we do not expect that the government would default on paying regular interest and principal at maturity.

In other words, Government securities are backed by the national treasury funds so they do not have default risk. However, corporate securities are exposed to default risk. Therefore, corporate securities with equal maturity, liquidity, and other features similar to government securities would sell at a higher rate of interest. In this case, the difference in interest rates between corporate and government securities of similar maturity, liquidity, and other features represent the default risk premium. For example, a 5-year Treasury bond yields 6.2 percent, while a 5-year corporate bond of similar liquidity and similar other features yields 6.7 percent. In this case, the default risk premium on the corporate bond is 0.5 percent (that is, 6.7 percent corporate yield minus 6.2 percent Treasury yield).

**liquidity Premium**

Liquidity refers to the marketability or convertibility of securities into cash. Investors generally prefer securities, which can be converted into cash without experiencing a loss in value. The securities, that are actively traded on over-the-counter markets, such as government securities and others issued by large and well-established corporations, always have higher liquidity. Since a potential loss in value will result from the need to sell quickly, a security with low liquidity would have a high liquidity risk.

In other words, if a security is not liquid, investors will add a liquidity premium [LP] when they determine the interest rates of such securities. Thus, liquidity premium is the additional return that investors require to compensate against a loss in the value of securities due to poor marketability. Lowering the marketability of securities, the investors expect a greater premium for liquidity. Hence, the market interest rate is higher for the securities with lower liquidity.

**Maturity Risk Premium**

We noted that government securities are free from default risk. Further, they are almost free from liquidity risk because there exist active markets for them. Therefore, market interest rates on government securities can be approximately thought of as the nominal risk-free rate, which is equal to the real risk-free rate plus an expected average inflation premium. We should also note that the price of all long-term securities will fall with a rise in the market interest rate. This is called interest rate risk.

However, the value of a security changes widely in response to a given change in interest rate, if it has a relatively longer term to maturity. In other words, if interest rates on otherwise similar risk-class securities suddenly rise due to a change in the money supply, the price of relatively longer-term securities will decline more.

As it is usually expected that the market interest rate will rise, long-term government securities are also exposed to interest rate risk. Thus, the market interest rates on government securities with a longer term to maturity require an adjustment with another risk premium called the maturity risk premium. The longer the maturity period, the greater the maturity risk premium and the higher the market interest rate expected by investors.

However, it should be noted that in contrast to the interest rate risk of longer-term bonds, short-term bonds are more exposed to reinvestment risk. The reinvestment risk refers to the chance that investors might have to reinvest their funds at a lower interest rate. The investment in short-term securities would create such a chance. If interest rate declines at the maturity of short-term securities, it would lead to a decline in interest income for investors from reinvestment. This would otherwise not happen if the funds were invested in long-term securities. Thus, short-term investors are more exposed to reinvestment rate risk due to the possibility of reinvestment at a lower rate.

Putting all these factors together, the market interest rates, denoted as k, can be expressed as:

okn = k* + IP + DRP + LP + MRP

Where,

okn = the market rate of interest on ‘n’ year security, which differs from one security to another depending upon the nature of risk associated.

k* = the real risk-free rate of interest that exists on a risk-free asset in the world with zero inflation.

IP = average expected inflation rate over the life of given securities.

DRP = the default risk premium that results because of the possibility that a borrower will not pay interest and principal within the stated time period.

LP = liquidity premium

MRP = the maturity risk premium reflected by price risk on a longer-term maturity bond.

- The quoted rate of interest on Treasury bills is the nominal risk-free rate.
- Treasury securities are free from default risk as they are backed by the government’s treasury funds.
- The securities issued by larger, well-established, and financially sound firms have lower default risk.
- Treasury securities are more liquid than corporate securities because of no default risk.

**FAQ’s(Frequently Asked Questions)**

### What is the Real Risk-Free Rate of Interest?

The risk-free rate of interest in the world with no inflation.

### What is the Nominal Risk-Free Rate of Interest?

The risk-free rate of interest plus premium for inflation.

### What is Default Risk Premium?

The Premium for risk of default of principal and interest payment.

### What is Liquidity Premium?

The premium for lower marketability of securities.

### What is a Maturity Risk Premium?

The premium for longer maturity of the securities.