Interest Rate Factors

Factors Determining the Interest Rate on a Loan/Bond:

i (j) = f (IP, RIR, DRPj, LRPj, SCPj, MPj)

Where,

• IP – #Inflation premium – Compensation for expected growth in the consumer price index;
• RIR – #Real interest rate – The required interest rate under zero inflation conditions;
• DRP (j) – #Default risk premium on the j security – Compensation for the probability of failing to pay the principal or interest on time;
• LRP (j) – #Liquidity risk premium on the j security – Compensation for the risk of being unable to sell the bond at the forecasted price quickly and at low costs;
• SCP (j) – Special feature #premium on the j security – Compensation for special features packaged with the bond, such as taxability, convertibility, callability, and other special conditions;
• MP (j) – #Maturity premium on the j security – Compensation for the risk associated with the time remaining until the full repayment of the loan.

Source:

Financial Markets and Institutions – by A. Saunders, M. Cornett & O. Erhemjamts