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Detail the components of the return to an investor in a treasury bond? Use an example...

Detail the components of the return to an investor in a treasury bond? Use an example in your answer.

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There are five components of the return to an investor in a treasury bond, which are as follows:

  1. The real risk free interest rate: This is the risk-free rate that investor can earn on their investment and this is the base rate to which all other investments are compared. Three-month US treasury bill can be considered as the risk-free rate.
  2. Inflation premium: Inflation premium is as addition to the return to an investment to adjust the future expectation of rise in inflation rate. For example, the inflation premium is low on the short term bond and higher on the long-term bonds as inflation will rise in long-term to a great extent rather than in a short-term period.
  3. Liquidity premium: Liquidity premium is a rate of return that investors earn on their investment as sometimes bonds doesn't trade very often. Therefore, to solve the liquidity problem inverstors earn liquidity premium over the risk-free interest rate. Size of liquidity premium depends on to what extent the market is active.
  4. Defult risk premium : Default risk premium is a premium that investors earn for believing that the company might get default in it's obligations in future. To compensate the future probability of getting default investors earn defaut premium on their investments.
  5. Maturity premium: Maturity premium is a premium that investors will earn to compensate the future value or maturity value of the bond as interest rate changes which effect the valuation of bonds. Suppose, A is having bonds worth $10,000 and earn 4% on it yearly with a maturity of 30 years. So, he will get $400 annually for holding a bond. On maturity he will get his $10,000 back. If you sell the bonds in a short-duration you will get the same amount. Maturity premium is the difference between 30 year treasury bond and 10 year treasury bond as 30 year treasury bond possess higher risk so investors will demand maturity premium to compensate that risk.

jeff jeffy answered 1 year ago
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