TEA.10.6

Description

This technical note provides a brief review of the components that make up the quoted, or nominal, market rate of interest on a given debt security and the conceptual relationship between the referenced market rate and its risk determinants. When comparing the well-being of an individual or firm before and after an intervening and causative event, it is common for an analyst to proceed by “(1) converting future utility into future dollars using standard principles of valuation, then (2) transform future dollars into present dollars by discounting at the market rate of return on capital, and finally (3) convert present dollars into present utility using standard principles of valuation.” The market rate of return on capital is often described as “the return that could have been earned on alternative investments at a specific level of risk.” Capital is generally composed of (1) debt and/or (2) equity. When discounting at a market rate of return with respect to debt, understanding the underlying risk determinants of the interest rate is of critical importance.