FINANCIAL
MARKETS AND INTEREST RATES 2-7
Pure Interest Rate
Risk-free
security in non-
inflationary
environment
The pure interest rate (r*) is the rate for a risk-free security when no
inflation is expected. This pure rate is also called the real, risk-free
rate. Most investors consider the interest rate on short-term U.S.
Treasury securities to be a close approximation for the real, risk-free
rate in a non-inflationary environment.
The pure rate constantly changes over time, depending on economic
conditions. The two most important influences on the risk-free rate
are the ones discussed above the expected rate of return
corporations and other borrowers can earn on their productive
assets (investment opportunities) and the time preference of
consumers for current-versus-future consumption. The real, risk-free
rate is difficult to calculate, but most researchers believe that
in recent years it has fluctuated between 2% and 4%.
Inflation
Erodes
purchasing
power over time
Inflation has a great influence on interest rates because it erodes
the purchasing power of money over time. Investors build in an
inflation premium to compensate for this loss of value. For example,
if the real, risk-free rate is 3%, and 8% inflation is expected for the
next year, the risk-free interest rate on one year U.S. Treasury bills is
11%.
r
T-Bill
= r* + IP
= 3% + 8%
= 11%
Note:
The 8% inflation rate is the expected future rate, not the past
inflation rate. It is also important to know that, for longer time
periods, the inflation premium is the expected average rate over that
period. For example, the inflation premium for a ten year security
would be the expected average annual inflation for the next ten years.
As with the risk-free rate, the inflation premium is not constant; it is
always changing based on investors' expectations of the future level of
inflation.