Real Risk Free rate r*
This is the rate on short term US treasury securities, assuming there is no inflation
Nominal risk free rate
It is calculated by adding the inflation premium to r*
Maturity risk premium MRP
This is the premium that reflects the risk associated with changes in interest rates for a long term security
Liquidity risk premium
This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value
Default Risk Premium DRP
This is the difference between the interest rate on the US treasury bond and a corporate bond of the same profits - that is, the same maturity and marketability.
Inflation Premium IP
This is a premium added to the real risk free rate to compensate for a decreased in purchasing power over time.
Production Opportunities
The investment opportunities in productive (cash-generating) assets
Time preferences for consumption
The preferences of consumers for current consumption as opposed to saving for future consumption
Risk
In a financial market context, the chance that an investment will provide a low or negative return
Inflation
The amount by which princes increase over time
The quoted (or nominal) interest rate on debt security, r, is
r=r*+IP+DRP+LP+MRP
Nominal, or quoted, risk-free rate, r sub RF
rED=r*+IP
Reinvestment rate risk
The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested
Term structure of interest rates
The relationship between yields and maturities
Yield Curve
A graph showing the relationship between bond yields and maturities
Normal yield curve
An upward sloping yield curve
Inverted (abnormal) yield curve
A downward sloping yield curve
Humped yield curve
A yield curve where interest rates on intermediate-term maturities are higher than rate on both short term and long term maturities
Pure expectations theory
A theory that states that the shape of the yield curve depends on investors expectations about future interest rates