Chapter 6 Corporate Finance

Real Risk-Free rate of interest (r*)

The rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected.

Nominal Risk-Free Rate ( rRF= r*+ IP)

It is the interest rate on a security free of unexpected inflation risk, default risk, liquidity risk

Inflation Premium (IP)

The premium built into interest rates to accommodate changes in the price level over time. It is the inflation rate expected in the future not the past

Default Risk Premium (DRP)

Some issuers may not be able to make the required coupon interest payments and return of principal at maturity

liquidity premium (LP)

The ability to buy and sell a bond issue freely

Maturity Risk Premium (MRP)

A premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk.

Nominal or Quoted rate

r = rRF + DRP + LP + MRP

Corporate Bond yield spread

Corporate bond yield - treasury bond yield = DRP + LP

Pure Expectations Theory

A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates.