The factors affecting interest rate are called determinants of interest rate. The market interest rate is the function of many factors including the real cost of money , inflation, risk ,etc. There are different determinant of market interest rate which are as follows:
Market Interest Rate ( K)= K* + IP + DRP + LRP +MRP
- K* = Real Risk Free Rate of interest
- IP = Interest Premium
- DRP= Default Risk Premium
- LRP= Liquidity Risk Premium
- MRP= Market Risk Premium
1.Real Risk Free Rate of interest (K*) :
Real Risk Free Rate is defined as the interest rate that would exist on a riskless security if no inflation were expected or when inflation is zero. In other words, it is the rate of interest from riskless government securities in the absence of inflation but this real rate of interest is never seen in the economy because inflation is never expected.
2. Nominal Risk free rate:
Nominal rate is defined as the actual rate of interest charged by the supplier of funds and paid by the demander of funds and it is always composed of real risk free rate of interest and premium of inflation.ie;
OK1 = K* + IP1/1
OK2 = K* + (IP1+IP2)/2
OK3 = K* + (IP1+IP2+IP3)/3
3. Default Risk premium (DRP) :
Default Risk premium is the risk that a borrower will default on a loan which means not pay the interest or the principal. Higher the default risk higher will be the interest rate and vice-versa.
K= K* + IP + DRP
Where , IP = Interest Premium , DRP= Default Risk Premium
Note: In Government Purposed Security, DRP=0
4. Liquidity Risk Premium (LRP) :
Liquidity Risk Premium is the premium charged for taking the risk on security with a weak liquidity risk premium.
K = K* + IP +DRP +LRP
5. Maturity Risk Premium (MRP) :
Maturity Risk Premium is the premium charged by the investor for capital loses due to the changes in the market interest rate.
K = K* + IP +DRP +LRP+MRP
Copyright : Shankar Mishra
Source : Finance I ( KEC publication)