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Janie is taking an exam in her history class. On the exam there is a question that asks her to state and discuss the five major causes of the Trans-Caspian War. Janie remembers four of them. She knows there is a fifth and can almost remember it; she knows that it is something like taxes. Janie is walking down the stairs, when all of a sudden, she remembers that the fifth point is taxes, but it is too late. Janie was suffering from
Inflation Premium (IP)
The premium added to the real risk-free rate of interest to compensate for the expected loss of purchasing power. The inflation premium is the average rate of inflation expected over the life of the security.
Default Risk Premium (DRP)
The additional yield that investors demand to compensate for the risk of default by the issuer of a bond beyond the risk-free rate.
Liquidity Premium (LP)
Liquidity Premium refers to the extra return investors demand to compensate for investing in securities with low liquidity or those difficult to sell quickly at market value.
Real Risk-free Rate
The rate of return on a risk-free investment, after adjusting for inflation. It represents the true purchasing power gained from investing.
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