5. Risk free rate – This is the interest rate that would exist on default free securities such as Treasury bills and bonds.
Risk free rate is made up of two components:
Real rate of return – interest rate if there was no inflation
Therefore risk free rate (RF) = Real rate of return + Inflation premium.
If risk premium is added to risk free rate, required rate of return is derived. Therefore required rate of return = real rate + inflation + premium + risk premium = Risk free rate + Risk premium.
6. Inflation premium – Investors are compensated for reduction in purchasing power of money. From point (1) the higher the inflation premium, the higher the market interest rate.
7. Default risk premium (DRP)
This is the rate added to risk free rate for possibility of default in payment of loans. Usually, its added if two securities have equal maturity and marketability.
8. Liquidity premium – This is premium added to equilibrium interest rate on a security if that security cannot be converted to cash on short notice and close to the original cost.
9. Maturity Risk Premium – a premium reflecting interest rate risk i.e risk of capital losses which investors are exposed to because of hanging interest rate over time.