Market interest rate can be defined as the rates of interests paid on deposits and other investments. The market interest rates are determined by the collaboration of supply and demand of funds in the financial market.

Determinants of market interest rate

Factors which affect the market interest rate are also known as the determinants of market interest rate. Market interest rate involves the function of several factors, which include inflation, risks and the real cost of money amongst others. The different determinants of market interest rate are as follows:

Market interest rate (K) = K* + IP +DRP + MRP + LRP, where:

  • K* = Real Risk-Free Rate of Interest
  • IP = Interest Premium
  • DRP = Default Risk Premium
  • MRP = Market Risk Premium
  • LRP = Liquidity Risk Premium.

K* (Real Risk-Free of Interest)

This is usually defined as the interest rate which is bound to exist in a security without risks if there is no inflation that is anticipated or when there is no inflation at all. In other words, Real Risk-Free of interest is the interest rate for government securities without risk, in the absence of inflation. However, the Real Risk-Free of interest can never be experienced in an economy because there is always inflation.

Nominal Risk – Free rate

A nominal rate defined as the real interest rate charged by the person supplying the funds, and paid by the person demanding the funds. It is always determined by the real-risk free interest rate and inflation premium. That is:

  • OK1 = K* + IP1/1
  • OK2 = K* + (IP1+IP2)/2
  • OK3 = K* + (IP1+IP2+IP3)/3

DRP (Default Risk Premium)

This is the risk in case a borrower defaults a loan i.e. if the borrower fails to pay the interest or the principal. The higher the default risk, the higher the interest rate and vice-versa.

  • K= K* + IP + DRP, where:

IP = Interest Premium

DRP= Default Risk Premium.

MRP (Maturity Risk Premium)

This is the premium the investor charges for capital losses caused by the changes in the market interest rate.

  • K = K* + IP +DRP +LRP+MRP

LRP (Liquidity Risk Premium)

This is the premium charged when a person takes a risk on security with LRP.

  • K = K* + IP +DRP +LRP