Real and nominal interest rates
Fisher’s Law
1 + i = ( 1 + r ) ( 1 + p)
= 1 + r + p + rp
i
= r + p
where i = nominal rate -- rate we see in newspaper or
TV, include inflation rate
r = real
rate -- without inflation, adjusted for inflation
p = inflation
rate
I
Structure of Interest Rates
1. Base interest rate
interest on Treasury --
fixed benchmark i in USA and world
on-the-run issue --
most recently auctioned Treasury for a gain maturity (greater liquidity)
2. Risk Premium
i on non-treasury
securities
= spread + i on on-the-run Treasury
securities (base i)
spread
(a) reflect the additional risk investors face
(b) risk premium
i on non-treasuries
factors that affect spread
(a) Issuer
(b) Issuer’s perceived creditworthiness (credit
risk)
(c) term or maturity of the instrument (longer,
the higher spread)
(d) embedded option (callable, convertible)
(e) Taxability of interest (municipal bond is exempt
from tax so rate is lower)
(f) liquidity of the issue (higher liquid or more
volume give the lower rate)