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TypesofRiskPremiums

Inflationriskpremium(IRP)compensation
fortheanticipatedinflationoverthelifeofthe
investment.

Defaultriskpremium(DRP)compensation
forthepossibilitythattheissuermaynotpay
theinterestorrepaytheprincipal.

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TypesofRiskPremiums(continued)
Maturityriskpremium(MRP)
compensationonlongertermbondsfor
valuefluctuationsinresponsetointerest
ratechanges.

Liquidityriskpremium(LRP)
compensationforabondthatcannotbe
quicklyconvertedintocashatafairmarket
value.

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DeterminantsoftheQuoted,or
Nominal,InterestRate
Nominal(quoted)interestrate=

k*+IRP+DRP+MRP+LRP

where
realriskfreerateofinterestorreturnfordelaying
consumption
premiumsfortakingonadditionalrisk
RememberAxiom1

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HowInterestRatesAffect
ExpectedReturns
Ifinterestratesaredown,
theexpectedreturnon
otherinvestmentsgoes
down.
Ifinterestratesareup,
theexpectedreturnon
otherinvestmentgoes
up.

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SourcesofRiskintheRiskreturn
Tradeoff
Interestraterisk Marketrisk
Inflationrisk Politicalandregulatory
Businessrisk risk
Financialrisk Exchangeraterisk
Liquidityrisk Callrisk

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InterestRateRisk
Riskassociatedwithfluctuationsinsecurity
pricesduetochangesinthemarketinterest
rate.
Ariseinthemarketinterestratereducesthe
valueofyourlowerratesecurity.
Impossibletoeliminate.

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InflationRisk
Riskthatrisingpriceswillerode
purchasingpower
Closelylinkedtointerestrate
riskbecauseoftheeffectof
inflationoninterestrates
Almostimpossibletoeliminate
Choosesecuritieswithareturn
higherthantheexpected
inflationrate

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BusinessRisk
Istheriskassociatedwith
poorcompany
managementorproduct
acceptanceinthe
marketplace
Variesbycompany

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FinancialRisk
Theriskassociated
withthecompanys
useofdebt.
Rememberthe
hierarchyof
payments.

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LiquidityRisk
Riskassociatedwithnotbeingableto
liquidateasecurityquicklyandcost
effectively.
Collectiblesandrealestatehavehighliquidity
risk.
Lessimportantwithalongerinvestment
horizon.

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