DRP default risk premium. This premium reflects the possibility that the issuer
will not pay interest or principal at the stated time and in the stated
amount. DRP is zero for U.S. Treasury securities, but it rises as the riski-
ness of issuers increases.
LP liquidity, or marketability, premium. This is a premium charged by lenders
to reflect the fact that some securities cannot be converted to cash on short
notice at a “reasonable” price. LP is very low for Treasury securities and
for securities issued by large, strong firms, but it is relatively high on secu-
rities issued by very small firms.
MRP maturity risk premium. As we will explain later, longer-term bonds, even
Treasury bonds, are exposed to a significant risk of price declines, and a
maturity risk premium is charged by lenders to reflect this risk.As noted above, since rRFr* IP, we can rewrite Equation 1-1 as follows:
Nominal, or quoted, rate r rRFDRP LP MRP.
We discuss the components whose sum makes up the quoted, or nominal, rate on a
given security in the following sections.The Real Risk-Free Rate of Interest, r*
Thereal risk-free rate of interest, r*,is defined as the interest rate that would ex-
istonarisklesssecurityifnoinflationwereexpected,anditmaybethoughtofasthe
rate of interest onshort-termU.S. Treasury securities in an inflation-free world. The
real risk-free rate is not static—it changes over time depending on economic condi-
tions, especially (1) on the rate of return corporations and other borrowers expect to
earn on productive assets and (2) on people’s time preferences for current versus fu-
ture consumption. Borrowers’ expected returns on real asset investments set an up-
per limit on how much they can afford to pay for borrowed funds, while savers’ time
preferences for consumption establish how much consumption they are willing to
defer, hence the amount of funds they will lend at different interest rates. It is diffi-
cult to measure the real risk-free rate precisely, but most experts think that r* has
fluctuated in the range of 1 to 5 percent in recent years.^10
Inadditiontoitsregularbondofferings,in1997theU.S.Treasurybeganissuing
indexed bonds,withpaymentslinkedtoinflation.Todate,theTreasuryhasissuedten
of these indexed bonds, with maturities ranging (at time of issue) from 5 to 31 years.
Yields on these bonds in November 2001 ranged from 0.94 to 3.13 percent, with the
higheryieldsonthelongermaturitiesbecausetheyhaveamaturityriskpremiumdue
to the fact that the risk premium itself can change, leading to changes in the bonds’
prices.Theyieldontheshortest-termbondprovidesagoodestimateforr*,becauseit
hasessentiallynorisk.32 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment(^10) The real rate of interest as discussed here is different from the currentreal rate as discussed in connection
with Figure 1-5. The current real rate is the current interest rate minus the current (or latest past) inflation
rate, while the real rate, without the word “current,” is the current interest rate minus the expected futurein-
flation rate over the life of the security. For example, suppose the current quoted rate for a one-year Trea-
sury bill is 5 percent, inflation during the latest year was 2 percent, and inflation expected for the coming
year is 4 percent. Then the currentreal rate would be 5% 2% 3%, but the expectedreal rate would be
5% 4% 1%. The rate on a 10-year bond would be related to the expected inflation rate over the next
10 years, and so on. In the press, the term “real rate” generally means the current real rate, but in econom-
ics and finance, hence in this book unless otherwise noted, the real rate means the one based on expectedin-
flation rates.
See http://www.
bloomberg.comand select
MARKETS and then U.S.
Treasuries for a partial listing
of indexed Treasury bonds.
The reported yield on each
bond is the real risk-free
rate expected over its life.