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Partes tres

All interest rates are divided into 3 parts:

  • the risk-free rate of interest,
  • the expected rate of inflation, and
  • a premium for default risk.

What is the risk-free rate of interest?

While most economists would say that the risk-free rate of interest is the interest rate on a government bond, that would contain inflation risk. As a result, it might possibly be better to think that an approximate measure of the risk-free rate of interest is the real rate of growth in total economic activity such as GDP. The term real means first deflating GDP for inflation.

What is the expected rate of inflation?

The expected rate of inflation is what credit market participants believe will be the inflation rate in the future. Credit market participants include both borrowers and lenders.

What is meant by a premium for default risk?

Different credit contracts will have different premiums for default risk. For example, the premium for default risk on US government obligations is very low, perhaps almost zero. In contrast, some states and municipalities have begun to default on some of their obligations. As a result, their debt would have a premium for default risk. Of course, corporate and personal debt instruments also have premiums for default risk.

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