CFA(3)

1. Opportunity Cost

• Interest rates can also be viewed as the opportunity cost of current consumption.
• If the market rate of interest on one-year securities is 5%,earning an anditional 5% is the opportunity forgone when current consumption is chosen rather than saving(postponing consumption).

2. The components of interest rate

• The real risk-free rate of interest is a theoretical rate on a single period loan that has no expectation of inflation in it. When we speak of a real rate of return, we are referring to an investor's increase in purchasing power(after adjusting for inflation).
• Since expected inflation in future periods is not zero, the rates we observe on T-bills, for example, are risk-free rates but not real rates of  return. T-bill rates are nominal risk-free rates because they contain an inflation premium. The approximate relation here is:
• Nominal risk-free rate=real risk-free rate+ expected inflation rate

3. The components of interest rate(con't)

• Securities may have one or more of several risks, and each added risk increases the required rate of return on the security. These types of risk are:
• Default risk--the risk that a borrower will not make the promised payments in a timely manner.
• Liquidity risk--the risk of receiving less than fair value for an investment if it must be sold for cash quickly.
• Maturity risk--the prices of longer-term bonds are more volatile than those of shorter-term bonds. Longer maturity bonds have more maturity risk than shorter-term bonds and require a maturity risk premium.
• Each of these risk factors is associated with a risk premium that we add to the nominal risk-free rate to adjust for greater default risk,less liquidity,and longer maturity relative to a very liquid, short-term,defalut risk-free rate such as that on U.S. Treasury bills. We can write:
• required interest rate on a security=nominal risk-free rate+defult risk premium+liquidity premium+maturity risk premium