Interest Rate Risk Explained With Relevant Examples

Interest is basically a reward paid by a borrower for the use of an asset, usually capital, belonging to a lender. It’s the compensation paid for the loss of use of the asset. We could also describe it as the opportunity cost of alternative investments.

At the time of lending, the lender most likely has a portfolio of investment vehicles to choose from. As such, they must charge a premium for the ‘loss’ of the alternative investment opportunities. We express interest as an annual percentage, from which we can calculate monthly, quarterly or semi-annual equivalents. The level of interest rate is a function of several risks.

Interest Rate Formula

$$ \begin{align*}
r & = \text{risk free rate} + \text{inflation premium} \\
& +\text{ liquidity premium} + \text{maturity premium} \\
& + \text{default premium}
\end{align*} $$

Types of Risks

The risk-free rate is the rate of return offered by assets largely considered risk-free. Usually, these are government securities or local authority bonds. The reason is that governments can always come up with ways of repaying their debts, for instance, by increasing the tax payable by its citizens.

Inflation Risk

Inflation risk is the loss of purchasing power of money due to the increase in prices of consumer goods.  A premium is added to the risk-free rate of interest to cushion investors from loss of purchasing power of money. The aim is to offset the additional cash that investors will have to pay when buying goods.

Financial analysts measure inflation on a monthly or yearly basis. They use corresponding periods to calculate inflation. For instance, to establish the inflation in June 2017, we have to compare the prices of selected consumer goods in June 2016 and June 2017.

Liquidity Risk

Liquidity risk refers to a situation where investors could find themselves unable to meet short-term liabilities due to investing their money in fixed-term assets. As a result, you could find a very profitable business undergoing liquidation or closure simply because of insufficient liquidity.

Major investments usually have fixed durations, and an investor cannot access funds until maturity. A financial analyst should set aside enough funds to cater for the day-to-day running of a company.

Default Risk

Default risk describes a situation where a borrower may cease to repay borrowed funds due to bankruptcy. This might result in significant losses on the side of the lender.

Maturity Risk

Lastly, maturity risk refers to the uncertainty associated with long-term investments. To protect themselves from these risks, lenders add a premium to the risk-free rate with respect to each risk.

Question

Which of the following statements is the most accurate about interest rates?

A. The risk-free rate is the rate of return offered by assets largely considered risk free such as corporate bonds.

B. Inflation risk describes a situation where a borrower may cease to repay borrowed funds as a result of bankruptcy.

C. The interest rate formula is: interest rate = risk-free rate + default premium + liquidity premium + inflation premium + maturity premium

Solution

The correct answer is C.

You must add the four types of risks to the risk-free rate to come up with the overall rate of interest, r.

Option A is incorrect. The risk-free rate is the rate of return offered by assets largely considered risk free such as government securities.

Option B is incorrect. Inflation risk is the loss of purchasing power of money as a result of the increase in prices of consumer goods.

Reading 6 LOS 6b
Explain an interest rate as the sum of the real risk-free rate and premiums that compensate investors for bearing distinct types of risk.