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LOS b: Explain an interest rate as the sum of a real risk-free rate, expected inflation, and premiums that compensate investors for distinct types of risk.

Which one of the following statements best describes the components of the required interest rate on a security?

A)	The nominal risk-free rate, the expected inflation rate, the default risk premium, a liquidity premium and a premium to reflect the risk associated with the maturity of the security.

B)	The real risk-free rate, the default risk premium, a liquidity premium and a premium to reflect the risk associated with the maturity of the security.

C)	The real risk-free rate, the expected inflation rate, the default risk premium, a liquidity premium and a premium to reflect the risk associated with the maturity of the security.

The required interest rate on a security is made up of the nominal rate which is in turn made up of the real risk-free rate plus the expected inflation rate. It should also contain a liquidity premium as well as a premium related to the maturity of the security.

A)	nominal risk-free rates because they do not contain an inflation premium.

B)	nominal risk-free rates because they contain an inflation premium.

C)	real risk-free rates because they contain an inflation premium.

T-bills are government issued securities and are therefore considered to be default risk free. More precisely, they are nominal risk-free rates rather than real risk-free rates since they contain a premium for expected inflation.

A)	approximately the nominal risk-free rate reduced by the expected inflation rate.

B)	exactly the nominal risk-free rate reduced by the expected inflation rate.

C)	approximately the nominal risk-free rate plus the expected inflation rate.

The approximate relationship between nominal rates, real rates and expected inflation rates can be written as:

Nominal risk-free rate = real risk-free rate + expected inflation rate.

Therefore we can rewrite this equation in terms of the real risk-free rate as:

Real risk-free rate = Nominal risk-free rate – expected inflation rate

The exact relation is: (1 + real)(1 + expected inflation) = (1 + nominal)