in this lesson we will talk about the
components that form interest rates every type of interest rate you are
familiar with mortgage leasing school loan investment loans can be
disaggregated as the sum of five components it is important to understand
this topic well because it enables you to be much more informed when
negotiating with the bank and investor or considering whether or not to make an
investment yourself the building block of all interest rates
is the real risk-free rate an interest rate that assumes no risk of default and
simply reflecting the time value of money the second component is expected
inflation as time goes by the market prices rise and purchasing power of
money is reduced that is why interest rates contain a component that accounts
for inflation and compensates for the reduced purchasing power of money such a
component is added to the real risk-free rate when someone burrows a given amount of
money there’s always a chance that he or she may not be able to repay the money
because of bankruptcy or is unable to repay part of the loan this is the
default risk component every borrower has a different default risk profile and
therefore this component is evaluated on a case-by-case basis the fourth component is called the
liquidity premium some investments are highly liquid US Treasury bonds for
example and have a low liquidity premium others are much less liquid a liquid
market gives investors options if they need their money in a short period of
time they will be able to sell their investment on the market on the other
hand if there isn’t a market it is much more difficult to exit at a given
position the investor will have to give a significant discount from the price in
order to stimulate buyers which will incur losses that’s why a liquid
security must compensate its owners through a higher interest rate the fifth and last component that forms
interest rates is the maturity premium a maturity premium is added to those
securities that have a longer duration all else being equal an investor would
require compensation for the longer duration of his or her investment given
that he or she will be unable to use the money for a longer period of time the sum of these five components and a
profit margin for the bank form the interest rates that we encounter on a
daily basis as we said earlier a good understanding of these components allows
us to have a much clearer idea and be stronger at negotiations Oh