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Interest Rate Refresher

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The various components are:

  • Real Interest Rate is the compensation, over and above inflation, that lenders demand to lend their money.
  • Inflation is by far the biggest enemy of a lender. Lenders want a return on their money to compensate them for the inflation they expect and the risk that their inflation expectation could be wrong.
  • Liquidity Risk Premium is the compensation that a lender receives for investing funds in something that is difficult to sell. The old adage “risk is having your money available when you need it” applies.
  • Credit Risk is the risk that the loan or bond will not be repaid as scheduled, or at all.