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Interest rate's a five-ingredient smoothie
It's a sum of five delicious parts
In this video
We're going to talk about the five components of interest rates
Hungry?
Let's make smoothie!
Our first ingredient is the real risk-free rate
"Real" means that the interest rate's expressed in terms of goods instead of money
If something's expressed in terms of money
we say that it's in nominal terms
For example
5% of 100 strawberries are 5 strawberries
and this 5% is in real terms
but 5% of $100 is $5
and this 5% is in nominal terms
so, real interest rate is measured in goods
so what?
Now this is the juicy part
If something's measured in real terms
or measured in terms of goods
it removes money from the equation
In a world with no money
there'll be no inflation
Inflation is the increase in the general price level
and the price level is measured with money, or measured in nominal terms
so, no money
no general price level
no inflation
This is the essense of real interest rate
It assumes there's no inflation over the loan period
so that the purchasing power of the interest you'll received in the future is the same as today
Let's move on to look at the risk-free element
"Risk-free" simply means that
you're absolutely certain the borrower will repay you the principle + interest at the agreed date
so there's no risk involved in your lending
Putting all of these together
real risk-free rate's simply the compensation for the lender
for giving up his money temporarily
Now off to our second ingredient
Expected inflation
Real interest rate assumes there'll be no inflation over the loan period
but that's unlikely in reality
so we have to add inflation back to our equation
When there's inflation
the lender can buy less with the interest he'll receive in the future
because everything's more expensive
so he'll require an inflation premium
to preserve his purchasing power
That brings us to default risk premium
Can the borrower repay me?
That's the question every lender asks
That's why banks check credit records of borrowers
and bond investors check the credit ratings of the bonds
Default risk premium
compensates investors for taking the risk of not getting repaid
the full amount of principle and interest on time
the higher the credit risk, the higher the premium
Easy!
Let's shake things up a bit by adding liquidity premium
It certainly makes things less dry
Liquidity refers to the ease of selling something
For example
it'll be easier to sell a share in facebook
than, say, an art sculpture of giant bunnies
Illiquid assets are harder to sell
because there're few buyers in the market
and they usually involve higher transaction costs
say, the transportation costs for the giant bunnies
so liquidity premium compensates investors for holding illiquid assets
Finally, we top the mixture with maturity premium
Maturity premium compensates investors
for the interest rate risks for holding longer maturity bonds
When interest rates go up
bond prices fall and investors lose
the prices of longer maturity bonds fall even more
because they're more sensitive to interest rate changes
This concept's called duration
and we'll cover that in later videos
so maturity premium compensates
for the interest rate risks
in longer maturity bonds
An easier way to think about maturity premium is that
if you invest in longer maturity bonds
your money will be locked up for longer
and you're more likely to miss attractive investment opportunities
so the longer the maturity, the higher the premium
Now blend the ingredients untill smooth
and you'll have this delicious strawberry smoothie
I mean interest rate
I hope this video is helpful to you
Are there any financial concepts you want to learn more about?
Be sure to let me know
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See you soon!