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Old 02-15-2019, 10:24 AM
Sina Sina is offline
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Join Date: Jan 2015
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Default Question about interest rate decomposition

Hi,

I have a quick question about decomposition of interest rate. I have a note that says:
"interest rate can be decomposed into 5 components:
  1. Real risk free rate (r)
  2. Maturity risk premium
  3. Default risk premium (s)
  4. Inflation premium (i_e, i_u, c, i_a)
  5. Liquidity premium"
And then we have: R=r+s+i_e+i_u-c+i_a, where
  • i_e=compensation for expected inflation
  • i_u=compensation for unexpected inflation
  • c=cost of inflation protection
  • i_a=actual inflation
Now in the formula for R=r+s+i_e+i_u-c+i_a, what terms exactly define "Maturity risk premium", "Inflation premium" and "Liquidity premium"?
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Old 02-23-2019, 04:41 PM
Robin_Cunningham Robin_Cunningham is offline
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College: University of North Carolina
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Default

"Maturity risk premium" - extra return for holding a bond with a longer maturity. If it is a corporate bond, you are taking a risk of default over a longer period.

"Inflation premium" - extra yield demanded to account for expected inflation.

"Liquidity premium" - Extra yield demanded for bonds that are harder to buy and sell than others. If a bond is privately-placed, for example, it is harder to liquidate if you would like to sell it, so extra yield is demanded versus more liquid bonds.

Hope this is helpful.
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