LOS A and B require us to:
a. interpret interest rates as required rates of return, discount rates, or opportunity costs, and
b. explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for bearing distinct types of risk.
a. The interest rates can be interpreted as one of the three rates, i.e. required rate of returns, the discount rate, and the opportunity cost.
b. For every single dollar that a lender is ready to lend, he would expect the following in return:
i. The risk-free rate of return, i.e. the amount of return that would be expected to be received, if the amount was lent to the government or other risk-less investment.
ii. The inflation premium, i.e. the return in order to retain the purchasing power against the expected inflation.
iii. The default risk premium, i.e. the premium to compensate for the credit risk that the investor is ready to assume. This risk varies from investment to investment.
iv. The liquidity premium, i.e. the premium to compensate for the liquidity risk assumed by the investor.
v. The maturity premium, for holding the investment till the maturity date. The longer the investment period, the higher is the premium.
All these premiums collectively form the required rate of return of an investor.
c. The discount rate is the same as the required rate of return. It is the rate at which the future cash flows are discounted to calculate the present value of the stream.
d. And if the market interest rate is, say X%, that means, the investor has to forego the return of X% if some other investment is made. Thus, X% is the opportunity cost of the investment made.