4. In determining the interest rate on bonds, we have to take into account the inflation...

4. In determining the interest rate on bonds, we have to take into account the inflation premium liquidity premium, maturity risk premium and the liquidity premium. US Treasury bonds are considered risk-free but what exactly does this mean in terms of these risk premia? Which of these risk premia is it not subject to and why?

Expert Solution

Inflation premium would be demanded by investors for compensating for expected Inflation which will be causing erosion in the value of capital.

Liquidity premium would be responsible for additional return that investors would be demanding because short term bonds will be more liquid than the long term bonds.

maturity risk premium will be the amount of extra money investors will be demanding for investment into Bond because they are exposed to the risk of holding these bonds over a longer period of time.

treasury bonds are considered risk free because they are backed by the central banks and the United States Government that they will repay the amount of principal and interest on the maturity so they are highly secured and they do not have the maturity risk.

United States treasury bonds are considered risk free but they are exposed to liquidity premium and inflation premium because they are not hedged from inflation and liquidity risk but they are hedged from maturity risk because the government is providing the bond holders with a guarantee that they are going to repay the amount of interest and principal on the date of maturity so there is no risk involving holding the longs for longer period of time so it can be said that United state treasury bonds will be exposed to the risk of inflation premium along with liquidity premium but they are not exposed to the risk of maturity risk premium.

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