Question

Explain the following

a. How would you explain a term premium of zero? Is the term premium likely to be highest during a business cycle expansion or contraction?

b. Using a combination of the expectations and segmented market theory of the yield curve, explain what factors would cause the term premium to decline?

c. Recently the term premium has been negative. What factors would contribute to a negative term premium?

Answer 1

A. The term premium of zero means that the investors are not going to ear anything in their long-term bonds or in the short-term bonds the term premium is basically the compensation received by the investors to hold long-term bonds or the short term bonds here the interest rates are received by the investors were expecting an average level of the risk-free rate and he is expected to receive compensation for the long period to hold the bonds.
Yes, the term premium is likely to highest during a business cycle when the cycle is expanding in the economy and in the contraction this premium will decrease this is the only reason why we are expecting a good premium in the period of expansion in the market.
B. The expected and segmented market theory is basically a theory where long and short-term interest rates of the bonds are not related to each other.
So here expected and segmented market theory which is based on the long-term and short-term bonds are totally in a different phase in explaining the market condition and situation.
With the help of yield curve which is the line which was the interest rate of bonds and represents credit quality but creating a different maturity date the slope of the year basically presents an idea of the future interest rate changes according to the economic activities.
C. In the recent situations the term premium has been negative so here the factors would contribute to a negative term premium are.
negative term period is basically a premium where the estimated rate of return on the particular investment is less than the risk-free rate then the expected result is called as a negative risk premium some factors which are really very important in the negative risk premium or unexpected market policies, unexpected market fluctuations, poor economic policies, poor economy structures.