Market interest rates

Because future inflation is unknown, there are three tactics.

* Charge X% interest 'plus inflation'. Many governments issue 'real-return' or 'inflation indexed' bonds. The principal amount and the interest payments are continually increased by the rate of inflations. See the discussion at real interest rate.
* Decide on the 'expected' inflation rate. This still leaves both parties exposed to the risk of 'unexpected' inflation.
* Allow the interest rate to be periodically changed. While a 'fixed interest rate' remains the same throughout the life of the debt, 'variable' or 'floating' rates can be reset. There are derivative products that allow for hedging and swaps between the two.

Default: There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. Loans to developing countries have higher risk premiums than those to the US government. An operating line of credit to a business will have a higher rate than a mortgage.

The credit worthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.

Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. See the discussion at time value of money. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges.

Length of time: Time has two effects.

* Shorter terms have less risk of default and inflation because the near future is easier to predict than events 20 year off.
* Longer terms allow for investments in larger projects with higher eventual returns. Contrast this to the lender's preference for readily available cash for contingencies. This is why banks pay higher interest on non-redeemable GICs than on chequing account balances.

Other: Borowers and lenders may face individual tax rates, transaction costs and foreign exchange rate risks. In a liquid market they cannot exert their personal preferences. It is the sum total of the participants who determine rates. The market for financial instruments has moved from the local, to the national, and is now international.

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