How a weaker economy affect the risk free component

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Reference no: EM131225821

Decomposing Interest Rate Movements:

The interest rate on a one-year loan can be decomposed into a one-year, risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium.

The risk-free rate is normally affected by changing economic conditions to a greater degree than is the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by

(a) the Treasury and

(b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation? Why?

Reference no: EM131225821

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