You are here

A market interest-rate model

29 April, 2015 - 15:38

A basic interest rate pricing model for an asset

i_n = i_r + p_e + rp + lp\,\!

Assuming perfect information, pe is the same for all participants in the market, and this is identical to:

i_n = i^*_n + rp + lp\,\!


in is the nominal interest rate on a given investment

ir is the risk-free return to capital

i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills).

rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default

lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).