A particular security’s equilibrium rate of return is 8 percent. For all securities, the inflation risk premium is 1.75 percent and the real interest rate is 3.5 percent. The security’s liquidity risk premium is .25 percent and maturity risk premium is .85 percent. The security has no special covenants. Calculate the security’s default risk premium. ( LG 2-6 )

( LG 2-6 )

So far we have looked at the general determination of equilibrium (nominal) interest rates for financial securities in the context of the loanable demand and supply theory of the flow of funds. In this section, we examine the specific factors that affect differences in interest rates across the range of real-world financial markets (i.e., differences among interest rates on individual securities, given the underlying level of interest rates determined by the demand and supply of loanable funds). These factors include inflation, the “real” interest rate, default risk, liquidity risk, special provisions regarding the use of funds raised by a security’s issuance, and the term to maturity of the security. We examine each of these factors in this section and summarize them in Table 2–3 .

Table 2–3