Question

c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.

Answer 1

1. Inflation premium: The amount is invested by an investor today and he gets the repayment of the principal amount after the maturity period. Suppose, if X makes an investment for 20 years. Do you think the money value of $100 will be the same even after 20 years? Think of what you could buy 5 years ago with $1 and what can you buy for $1 today. So over a period of time, the inflation rises, so the investor needs to be compensated for this loss.

Short term US security: Since inflation is a phenomenon that comes into play over a period of time, it is not included in the short term.

Long term US security: It is considered while determining the interest rate. so longer the term of security, the higher will be the inflation premium.

Short term corporate securities: It is not considered in short term securities.

Long term corporate securities: Inflation definitely tends to raise the interest rate demanded by the investors in long term security.

2. Default risk: It is the risk associated with debt instruments that the borrower will not be able to fulfill his debt obligation. So higher the risk of default, the higher will be the premium for default.

Short term US security: The treasury securities are considered almost default-free. The govt. is supposed to always make its debt repayment.

Long term US security: The treasury securities are considered almost default-free. The govt. is supposed to always make its debt repayment.

Short term corporate securities: The corporate securities do carry a premium for default risk but it will be smaller compared to the longer-term corporate securities.

Long term corporate securities: The longer the maturity period of corporate security, the higher will be the default risk and therefore higher is the premium.

3. Liquidity Premium: The ability of a security to be readily traded in the market is its liquidity. The easily a security gets bought and sold in the market determines the liquidity of the security. So the more liquid security is, the better it is for an investor. A security that is more liquid will have less liquidity premium and vice versa.

Short term US security; The treasury securities are liquid so these do not have much a liquidity issue, Therefore not considered here.

Long term US security: These securities are considered the safest, so they tend to get buyers and sellers easily.

Short term corporate securities: If the security is illiquid, the premium added will be higher.

Long term corporate securities: The risk of liquidity is the highest in the long term, therefore the premium is higher in comparison to the short term securities.

4. Maturity risk premium: This premium compensates an investor for holding securities with a lengthly maturity period. The longer the period, the higher is the risk and therefore higher is the premium.

Short term US security: No maturity risk premium.

Long term US security: These securities are the safest and maturity risk is not there.

Short term corporate securities: The premium rises with the low credit companies and companies with good credit ratings have lesser maturity risk premiums.

Long term corporate securities: This premium is higher in case of long term securities as compared to the short term securities.