Nominal interest rates comprises of a risk free interest rate and a risk premium. The risk free interest rate is the interest rate at which a security that does not have any risk will attract. In other words, it is the interest that is paid on risk-free assets. The asset that is commonly assumed to be risk-free is government securities. Although government securities may not be entirely risk free they inherently have very low risk. Therefore, the interest rate on government securities is often assumed to be the risk free rate. Risk premium compensates investors for assuming additional risk. It is assumed that investors are risk averse. Therefore, they prefer less risk to more risk. In order to assume additional risk, they have to be compensated with risk premium. The sum of the risk free interest rate and risk premium gives the nominal interest rate. For example, assume that the risk free interest rate is 3 percent and the risk premium for a given asset based on its riskiness is 6 percent. The nominal interest rate will be as follows.
Nominal interest rate = 3% + 6% = 9%
Nominal risk can also be decomposed to the real interest rate and inflation. Inflation is the general rise in prices. Therefore, it compensates investors for the loss in money value as prices rise. Real interest is the interest rate that will be charged in the absence of inflation. Assuming that the risk free interest rate is 5 percent and the inflation rate is projected at 4 percent, the nominal interest rate will be as follows
Nominal interest rate = 5% + 4% = 9%
In conclusion, nominal interest rates can be discomposed in two ways. It can be decomposed on the basis on risk or on the basis of inflation.
References
Khan, W. (2004). Financial Management: Text, Problems And Cases. New York: Tata McGraw-Hill Education.
Shim, J., & Siegel, J. (2008). Financial Management (New ed.). New York: Barron's Educational Series.
