Smith Enterprises is looking to obtain a loan for short term cash use due to a projected cash flow problem. The Bank of MA charges an interest rate of 14%. The assessed default risk on a two year loan is 3%, liquidity risk of 2%, maturity risk of 2%. The inflation is expected to be 4% the first year and 6% the second year. What is the implied pure rate of interest?
A pure interest rate is the risk free interest rate, which is equal to the interest rate given in a government bond or a governement security. In the case of loan, the loss of liquidity is the pure interest rate. The time period for which the lender is giving money is compensated through that.
An interest rate will be made of
Pure interest rate+Expected Inflation+Liquidity Premium+Default Risk+Maturity Premium (the repayment of loan will get affected by the interest rate charged at that time)
In this case the gross interest is provided as 14%
Maturity Risk/ Premium- 2%
Liquidity Risk: 2%
Default Risk: 3%
Inflation as this is for two years, the expected inflation taken is 6%
Putting all the values in the formula: Pure Interest Rate: = 14%-6%-2%-3%-2%= 1%
The pure interest rate is 1%