Explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for bearing distinct types of risk.
The real risk-free rate is a theoretical rate on a single-period loan when there is no expectation of inflation. Nominal risk-free rate = real risk-free rate + expected inflation rate.
Securities may have several risks, and each increases the required rate of return. These include default risk, liquidity risk, and maturity risk.
The required rate of return on a security = real risk-free rate + expected inflation + default risk premium + liquidity premium + maturity risk premium.
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