Question

13，Distinguish between the concepts of the maturity-risk premium and the liquidity-risk premium.

14，Identify three prominent theories that attempt to explain the term structure of interest rates.

Answer 1

13. The investments in securities are exposed to various kind of risk like interest rate risk, credit risk, default risk, maturity risk, liquidity risk etc.

Maturity risk premium is related to the greater price sensibility of longer term securities in comparison of shorter term securities. The maturity risk premium is the compensation which investors demand for taking on more risk, therefore the expected rates of return on longer term securities are normally higher than rates on shorter term securities.

Liquidity-risk premium is associated to the concept that how fast the investments can be converted into cash. Illiquid investments carry more risk in comparison of liquid investments therefore investors demand liquidity risk premium on comparatively illiquid investments.

14. Three prominent theories that attempt to explain the term structure of interest rates are -

1. The Market Segmentation Theory: this theory purposes the term structure of interest rates is determined solely by the demand for and supply of securities for a specific maturity. According to market segmentation theory the term structure of interest rates for a given maturity is independent from demand and supply of the securities of different maturities.
2. The Expectations Theory: this theory describes the term structure of interest rates are in equilibrium where long-term rates are equal to short term rates.
3. The Liquidity Preference Theory: this theory describes that the investors always prefer the higher liquidity of short-term debt and therefore any deviation from a normal curve is for short term.