ECN 204 Study Guide - Credit Risk, Liquidity Premium, Liquidity Risk
23 Apr 2014
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Chapter 7 types and costs of financial capital. Formal historical accounting procedures include explicit records of debt (interest and principal) and dividend capital costs. In debt markets, the sup- ply and demand for funds determines the interest rate new borrowers must agree to pay: riskier debt costs more. Default risk: risk that a borrower will not pay the interest and/or principal on a loan. Nominal interest rate (rd): observed or stated interest rate. Real interest rate (rr): interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest: rd = rr + ip + drp +lp +mp. More generally, for more complicated risky debt securities at various maturities and liquidities. Borrowers must pay more than the real rate (rr) to compensate the lender (supplier of debt funds) for an inflation premium (ip), a default risk premium (drp), a marketability or liquidity premium (lp), and a maturity premium (mp)
