Question

e. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when 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.

Answer 1

Inflation premium is the add up interest rate added to the securities to compensate for decrease purchasing power of money due to inflation.

Default premium is the add on interest rate for a security to compensate for the credit risk of the investment

Liquidity premium add up a rate for lack of transactional efficiency for a security. It is added up because security cannot be easily sold at the value. If a security has to be sold immedietly, it will have to be quoted at discount.

Maturity risk premium is add up interest rate for increasing time to maturity. With more time to maturity, there is more probability for deafult.

(1) short-term U.S. Treasury securities- Inflation premium
2) long-term U.S. Treasury securities, - Inflation premium and liquidity premium
3) Short term corporate securities- Inflation premium and liquidity premium and Default risk premium
4) Long term corporate securities- Inflation premium, liquidity premium, default risk premium and Maturity risk premium

With time maturity premium and liquidity premiums increase as long term securities have more default risk and are less liquid. The inflation premium over time will depend on the expected rate of inflation.