Contrast the parts that make up an interest rate
The idea
A nominal interest rate can be decomposed into a real risk-free rate plus premiums for the risks the lender takes: expected inflation, default, liquidity and maturity. The real risk-free rate compensates for deferring consumption alone. Each premium answers a distinct question — will the money be worth less, will it be repaid, can the claim be sold, and how long is it tied up. Reading a yield as a single number hides which of these has moved, and it is usually the change in one premium, not the whole rate, that a piece of news is actually about.
A practice question
What does the real risk-free rate compensate a lender for?
- Deferring consumption, with no allowance for inflation or default — correct
- The risk that the borrower defaultsWhy not: That is the default premium, added on top. The real risk-free rate assumes repayment is certain.
- The loss of purchasing power from inflationWhy not: That is the inflation premium. 'Real' means inflation has already been stripped out.
The real risk-free rate is the pure price of time. Inflation and default are compensated by separate premiums layered on top of it.
A harder one
A corporate bond yields more than a government bond of identical maturity. Which premiums most likely explain the difference?
- The maturity premium and the real rateWhy not: Identical maturity means the maturity premium is shared, and the real risk-free rate is common to both.
- Default and liquidity premiums — correct
- The inflation premium aloneWhy not: Both bonds are exposed to the same inflation over the same horizon, so that component cannot explain a gap between them.
Identical maturity means the maturity premium and inflation expectations are largely shared. What differs is the chance of not being repaid and the ease of selling the claim.
The hardest tier
Government yields are unchanged while corporate yields rise. What does this most likely indicate?
- Inflation expectations have risenWhy not: That would lift both curves together — government bonds are just as exposed to inflation.
- The real risk-free rate has fallenWhy not: Also shared. A move in the real rate shows up in government yields first, and they have not moved.
- Credit or liquidity premiums have widened — correct
Shared components would move both curves together. When only corporate yields move, the change is in the premiums unique to corporate credit — which is exactly what a credit spread measures.
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