Nominal Rate (r)

The stated or quoted interest rate Includes inflation What you actually see on loans, bonds, CDs - Example bond yielding 8%

Real Rate (r*)

• The rate after removing inflation

• Reflects true purchasing power

r∗≈r−inflationr∗=r−inflation

Risk-Free Rate (RFR)

• Base rate (no risk)

• Usually proxied by U.S. Treasury securities

• Includes:

  • Real rate

  • Expected inflation

Default Risk Premium (DRP)

• Extra return for risk the borrower might not repay

• Higher for risky companies

Corporate bonds > Treasury bonds

Liquidity Premium (LP)

• Compensation for difficulty selling the asset quickly

• Less liquid = higher LP

Maturity Risk Premium (MRP)

• Risk from interest rate changes over time

• Longer maturity = higher MRP

Yield Curve

shows the relationship between:

• Interest rates (yields)

• Time to maturity

U.S. Treasury Yield Curve

• Considered default risk-free

• Shapes:

  • Normal (upward) → economy growing

  • Inverted → recession signal

  • Flat → transition

Corporate Yield Curve

always above treasury curve

Difference= credit (default) risk

Pure Expectations Theory

• Long-term interest rates reflect expected future short-term rates

• ignores MRP

Yield to Maturity (YTM)

• The total return if held to maturity

• The true cost of debt for the firm

Risk–Reward Tradeoff

The principle that higher risk → higher expected return

Stand-Alone Risk

• Risk of a single asset by itself

• Measured by standard deviation (σ)

Portfolio Risk

• Risk of an asset within a diversified portfolio

• Depends on:

  • Correlation with other assets

  • Contribution to overall risk

Diversifiable Risk (Firm-specific)

• Can be eliminated by diversification

• Examples:

  • Strikes

  • Lawsuits

  • Management issues

Market Risk (Systematic Risk)

• Cannot be diversified away

• Affects all firms

👉 Examples:

• Recession

• Interest rates

• Inflation

Common Stock

• voting rights

• dividends vary

Preferred Stock

Fixed dividend

no/limited voting

paid before common stock

market price

What investors are currently willing to pay