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U.S. Treasury securities are free of default risk in the sense that one can be virtually certain that the federal government will meet the scheduled interest and principal payments on its bonds. Therefore, the default risk premium on Treasury securities is essentially zero. Further, active markets exist for Treasury securities, so their liquidity premiums are also close to zero. Thus, as a ?rst approximation, the rate of interest on a Treasury bond should be the risk-free rate, rRF, which is equal to the real risk-free rate, r*, plus an in?ation premium, IP. However, an adjustment is needed for longterm Treasury bonds. The prices of long-term bonds decline sharply whenever interest rates rise, and since interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called interest rate risk. As a general rule, the bonds of any organization, from the U.S. government to Enron Corporation, have more interest rate risk the longer the maturity of the bond.15 Therefore, a maturity risk premium (MRP), which is higher the longer the years to maturity, must be included in the required interest rate.

The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds. This premium, like the others, is dif?cult tomeasure, but (1) it varies somewhat over time, rising when interest rates are more volatile and uncertain, then falling when interest rates are more stable, and (2) in recent years, the maturity risk premium on 30-year T-bonds appears to have generally been in the range of one to three percentage points.

We should mention that although long-term bonds are heavily exposed to interest rate risk, short-term bills are heavily exposed to reinvestment rate risk. When shortterm bills mature and the funds are reinvested, or “rolled over,” a decline in interest rates would necessitate reinvestment at a lower rate, and this would result in a decline in interest income. To illustrate, suppose you had $100,000 invested in one-year T-bills, and you lived on the income. In 1981, short-term rates were about 15 percent, so your income would have been about $15,000. However, your income would have declined to about $9,000 by 1983, and to just $5,700 by 2001. Had you invested your money in long-term T-bonds, your income (but not the value of the principal) would have been stable.16 Thus, although “investing short” preserves one’s principal, the interest income provided by short-term T-bills is less stable than the interest income on long-term bonds.

Write out an equation for the nominal interest rate on any debt security.

Distinguish between the real risk-free rate of interest, r*, and the nominal, or
quoted, risk-free rate of interest, rRF.
How is in?ation dealt with when interest rates are determined by investors in the
?nancial markets?
Does the interest rate on a T-bond include a default risk premium? Explain.
Distinguish between liquid and illiquid assets, and identify some assets that are liquid and some that are illiquid.
Brie?y explain the following statement: “Although long-term bonds are heavily exposed to interest rate risk, short-term bills are heavily exposed to reinvestment rate risk. The maturity risk premium re?ects the net effects of these two opposing forces.”

Taken From : Five-Minute MBA – Corporate Finance

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