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Old 02-15-2019, 10:24 AM
Sina Sina is offline
Join Date: Jan 2015
Posts: 1
Default Question about interest rate decomposition


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
Join Date: Jan 2019
College: University of North Carolina
Posts: 1

"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.
Robin Cunningham
Live Online Courses at UNC
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