Question

Lola wants to make an 6% real return on a loan that she is planning to make, and the expected inflation rate during the period of the loan is 5%. She should charge an interest rate of

Answer 1

11%

Step-by-step explanation:

Interest rate is considered to be composed of following components:

- Real risk free interest rate

- Inflation premium*

- Default risk premium

- Liquidity premium

- Maturity premium

Based on above, interest rate (r) is equal to:

r = real risk free interest rate + Inflation premium + Default risk premium + liquidity premium + maturity premium

In our example, assuming that Lola has computed 6% as total of all components except for inflation premium, so total she should charge 11% (6% + 5% inflation premium).

*Inflation premium pays off for expected inflation over the period of loan.