Determinants of interest rates (for the CFA Level 1 exam)

Summary

This lesson explores the determinants of interest rates, defining them as the relationship between cash flows at different times. It discusses three key interpretations: required rates of return, discount rates, and opportunity costs. The foundational component of interest rates is the real risk-free rate, supplemented by various premiums, including inflation, default risk, liquidity, and maturity premiums. The lesson emphasizes how these elements interact to influence nominal risk-free rates and provides a logical framework for analyzing investment scenarios, highlighting the importance of understanding the relationships and premiums that affect rates of return.

Takeaways

• 😀 Interest rates establish the relationship between cash flows at different times, impacting lending and investment decisions.
• 😀 The required rate of return reflects the compensation expected for lending money, demonstrating the basic principle of investment returns.
• 😀 The discount rate is crucial for determining the present value of future cash flows, essential for investment analysis.
• 😀 Opportunity cost emphasizes the trade-off between current consumption and potential investment returns.
• 😀 The real risk-free rate is the foundation of interest rates, representing the return on a risk-free investment without inflation.
• 😀 The inflation premium compensates investors for the anticipated loss of purchasing power due to inflation.
• 😀 The default risk premium accounts for the possibility of borrower default, influencing the overall return required by investors.
• 😀 The liquidity premium is essential for investments that lack marketability, requiring additional return for illiquidity.
• 😀 The maturity premium reflects the additional risk associated with long-term investments, making them sensitive to interest rate changes.
• 😀 When estimating interest rates for new investments, adjust known premiums from similar investments to derive expected returns.

Q & A

What is the primary purpose of interest rates?

Interest rates establish the relationship between cash flows that occur at different times, allowing investors to evaluate returns on investments.

What are the three interpretations of interest rates mentioned in the script?

The three interpretations are: 1) Required rate of return, 2) Discount rate, and 3) Opportunity cost of current consumption.

What is the real risk-free rate of interest?

The real risk-free rate is the expected return on an investment with no inflation and no risk, essentially compensating for delaying consumption.

How does inflation impact interest rates?

Inflation affects interest rates through the inflation premium, which compensates investors for the erosion of purchasing power over time.

What is the difference between nominal and real interest rates?

The nominal interest rate includes the inflation premium in addition to the real risk-free rate, while the real interest rate excludes the effects of inflation.

What is the default risk premium?

The default risk premium is compensation for the possibility that a borrower may fail to make payments as promised, affecting the expected return on investment.

Why is liquidity important when considering interest rates?

Liquidity impacts interest rates because illiquid investments may require a liquidity premium to compensate for the risk of selling them at a discount.

What does the maturity premium represent?

The maturity premium represents additional compensation required by investors for the increased sensitivity of long-term investments to interest rate changes.

How can one estimate the interest rate for a new investment based on existing data?

To estimate the interest rate for a new investment, one can analyze similar investments' characteristics, adjusting for differences in risk profiles using known premiums.

What range was determined for the interest rate of a four-year investment characterized by low default risk and low liquidity?

The estimated interest rate for the four-year investment was found to be between 2.8% and 5.8%.