Interest Rate Components

Interest rates are the "price" that lenders charge for lending their money to borrowers. There are many components to interest rates, each reflecting a form of compensation to the lender.

The various components are:

• A Real Interest rate is the compensation, over and above inflation, that a lender demands to lend his money ;

• Inflation is by far the biggest enemy of a lender. Lenders want a return on their money which compensates them for the inflation they expect and the risk that their inflation expectation could be wrong ;

• The Liquidity Risk Premium is the compensation that a lender receives for investing funds in something that is difficult to sell. The old adage "risk is having your money available when you need it" applies ;

• Credit Risk is the risk that the loan or bond will not be repaid as scheduled, or at all .

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