This is the rate for a short-term riskless security when inflation is expected to be zero.
It is calculated by adding the inflation premium to r*.
This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time.
It is based on the bond’s credit rating; the higher the rating, the lower the premium added, thus lowering the interest rate.
It is based on the bond’s marketability and trading frequency; the less frequently the security is traded, the higher the premium added, thus increasing the interest rate.
As interest rates rise over time, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain over the life of the security, this premium is added as a compensation for this uncertainty.
