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Interest rate
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==Market rates== There is a [[Market (economics)|market]] for investments, including the [[money market]], [[bond market]], [[stock market]], and [[currency market]] as well as retail [[bank]]ing. Interest rates reflect: * The [[risk-free interest rate|risk-free cost of capital]] * Expected [[inflation]] * [[Risk premium]] * [[Transaction cost]]s ===Inflationary expectations=== According to the theory of [[rational expectations]], borrowers and lenders form an expectation of [[inflation]] in the future. The acceptable nominal interest rate at which they are willing and able to borrow or lend includes the [[real interest rate]] they require to receive, or are willing to pay, plus the rate of [[inflation]] they expect. Under behavioral expectations, the formation of expectations deviates from rational expectations due to cognitive limitations and information processing costs. Agents may exhibit myopia (limited attention) to certain economic variables, form expectations based on simplified heuristics, or update their beliefs more gradually than under full rationality. These behavioral frictions can affect monetary policy transmission and optimal policy design.<ref>{{cite journal |doi=10.1016/j.jfs.2023.101151 |title=Optimal monetary policy under bounded rationality |journal=Journal of Financial Stability |volume=67 |pages=101151 |year=2023 |last1=Benchimol |first1=Jonathan |last2=Bounader |first2=Lahcen |hdl=10419/212417 |url=http://www.imf.org/external/pubs/cat/longres.aspx?sk=47048 |hdl-access=free }}</ref> ===Risk=== The level of [[risk]] in investments is taken into consideration. [[volatility (finance)|Riskier]] investments such as [[share (finance)|shares]] and [[junk bond]]s are normally expected to deliver higher returns than safer ones like [[government bond]]s. The additional return above the risk-free nominal interest rate which is expected from a risky investment is the [[risk premium]]. The risk premium an investor requires on an investment depends on the [[risk-neutral measure|risk preferences]] of the investor. Evidence suggests that most lenders are risk-averse.<ref>Benchimol, J., 2014. [https://ideas.repec.org/a/eee/reecon/v68y2014i1p39-56.html Risk aversion in the Eurozone], [[Research in Economics]], vol. 68, issue 1, pp. 39β56.</ref> A '''maturity risk premium''' applied to a longer-term investment reflects a higher perceived risk of default. There are four kinds of risk: * [[repricing risk]] * [[basis risk]] * yield curve risk * optionality ===Liquidity preference=== Most economic agents exhibit a [[liquidity preference]], defined as the propensity to hold [[cash]] or highly liquid assets over less [[Fungibility|fungible]] investments, reflecting both precautionary and transactional motives. Liquidity preference manifests in the yield differential between assets of varying maturities and convertibility costs, where cash provides immediate transaction capability with zero conversion costs. This preference creates a term structure of required returns, exemplified by the higher yields typically demanded for longer-duration assets. For instance, while a 1-year loan offers relatively rapid convertibility to cash, a 10-year loan commands a greater liquidity premium. However, the existence of deep secondary markets can partially mitigate illiquidity costs, as evidenced by US [[Treasury bond]]s, which maintain significant liquidity despite longer maturities due to their unique status as a safe asset and the associated financial sector stability benefits.<ref>{{cite journal |doi=10.1086/666589 |title=The Aggregate Demand for Treasury Debt |journal=Journal of Political Economy |volume=120 |issue=2 |pages=233β267 |year=2012 |last1=Krishnamurthy |first1=Arvind |last2=Vissing-Jorgensen |first2=Annette |url=http://www.minneapolisfed.org/research/SR/SR410.pdf }}</ref><ref>{{cite journal |doi=10.1016/j.jfineco.2015.09.001 |title=The impact of Treasury supply on financial sector lending and stability |journal=Journal of Financial Economics |volume=118 |issue=3 |pages=571β600 |year=2015 |last1=Krishnamurthy |first1=Arvind |last2=Vissing-Jorgensen |first2=Annette }}</ref> ===A market model=== A basic interest rate pricing model for an asset is : <math>i_n = i_r + p_e + r_p + l_p\,\!</math> where : ''i<sub>n</sub>'' is the nominal interest rate on a given investment :''i<sub>r</sub>'' is the risk-free return to capital : ''i*<sub>n</sub>'' is the nominal interest rate on a short-term risk-free liquid bond (such as U.S. [[treasury bill]]s). : ''r<sub>p</sub>'' is a risk premium reflecting the length of the investment and the likelihood the borrower will default : ''l<sub>p</sub>'' is a liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods). : ''p<sub>e</sub>'' is the expected inflation rate. Assuming perfect information, ''p<sub>e</sub>'' is the same for all participants in the market, and the interest rate model simplifies to : <math>i_n = i^*_n + r_p + l_p\,\!</math> ===Spread=== The ''spread'' of interest rates is the lending rate minus the deposit rate.<ref>[http://data.worldbank.org/indicator/FR.INR.LNDP Interest rate spread (lending rate minus deposit rate, %)] from [[World Bank]]. 2012</ref> This spread covers operating costs for banks providing loans and deposits. A ''negative spread'' is where a deposit rate is higher than the lending rate.<ref>[http://definitions.uslegal.com/n/negative-spread/ Negative Spread Law & Legal Definition], retrieved January 2013</ref>
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