We can view an interest rate as composed of a risk-free interest rate plus a collection of compensatory premiums. Which one of these premiums is likely increasing under our current economic circumstances? If this premium increase causes interest rates to rise over the next year, what will happen to the present value of all assets that provide future cash flows?
The real risk-free interest rate is the single-period interest rate for a completely risk-free security if no inflation were expected. In economic theory, the real risk- free rate reflects the time preferences of individuals for current versus future real consumption. The inflation premium compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt. Inflation reduces the purchasing power of a unit of currencythe amount of goods and services one can buy with it. The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate.' Many countries have govern- mental short-term debt whose interest rate can be considered to represent the nominal risk-free interest rate in that country. The interest rate on a 90-day U.S. Treasury bill (T-bill), for example, represents the nominal risk-free interest rate over that time horizon.? U.S. T-bills can be bought and sold in large quantities with minimal transaction costs and are backed by the full faith and credit of the U.S. government. The default risk premium compensates investors for the possibility that the bor- rower will fail to make a promised payment at the contracted time and in the con- tracted amount The liquidity premium compensates investors for the risk of loss relative to an investment's fair value if the investment needs to be converted to cash quickly. U.S. T-bills, for example, do not bear a liquidity premium because large amounts can be bought and sold without affecting their market price. Many bonds of small issuers, by contrast, trade infrequently after they are issued; the interest rate on such bonds includes a liquidity premium reflecting the relatively high costs (including the impact on price) of selling a position. The maturity premium compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended, in general (holding all else equal). The difference between the interest rate on longer- maturity, liquid Treasury debt and that on short-term Treasury debt reflects a posi- tive maturity premium for the longer-term debt (and possibly different inflation premiums as well)
