Nominal interest rates Interest rates as they are normally observed and quoted, with no adjustment for inflation. Real interest rates Interest rates adjusted for the effect of inflation, calculated as the nominal rate less the rate of inflation.
Traditional Theories of the Term Structure Expectations theory The term structure of interest rates is a reflection of financial market beliefs regarding future interest rates. Maturity preference theory Long-term interest rates contain a maturity premium necessary to induce lenders into making longer term loans.
Traditional Theories of the Term Structure Market segmentation theory Debt markets are segmented by maturity, with the result that interest rates for various maturities are determined separately in each segment.
Long-term bond prices are much more sensitive to interest rate changes than short-term bonds. This is called interest rate risk .
So, the modern view of the term structure suggests that:
NI = RI + IP + RP where NI = Nominal interest rate RI = Real interest rate IP = Inflation premium RP = Interest rate risk premium
Liquidity and Default Risk NI = RI + IP + RP + LP + DP where NI = Nominal interest rate RI = Real interest rate IP = Inflation premium RP = Interest rate risk premium LP = Liquidity premium DP = Default premium