Discuss the two major factors that determine the market nominal risk-free rate.

Question:

Discuss the two major factors that determine the market nominal risk-free rate.

Nominal Risk-Free Rate:

The nominal risk-free rate is the rate on government securities. Although the rate on short term sovereign securities is not truly risk-free, it may be considered as risk-free for practical purposes.

Answer and Explanation:

The two major factors that determine the nominal risk-free rate are:

  • Real risk-free rate - is the risk-free rate that should be equal across the economies and which does not consider the effect of inflation. Theoretically, it should be the same for all countries.
  • Inflation Rate - is the general increase in prices for a given economy. The risk-free rate compensates for inflation because nobody would want to see a depreciation in the value of their investment.

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How to Calculate Risk Premium: Definition & Formula

from Financial Accounting: Help and Review

Chapter 5 / Lesson 26
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