How to Calculate Maturity Risk Premiums
Original post by Cynthia Hartman of Demand Media
When analysts or investors gather information to estimate the required return on a bond, they build up the projected return by layering a series of premiums on top of the risk-free rate. The risk-free rate represents the interest rate, or return, on bond securities that have no risk of default. Premiums for factors such as maturity risk, inflation, default risk and liquidity increase the return an investor requires in exchange for investing in a particular bond.
Familiarize your self with the concept of the maturity risk premium. A risk premium for maturity compensates investors for holding securities over time. Thus, longer-term bonds have higher maturity risk premiums. With longer maturities comes more uncertainty about the economy and payback ability for the bond. The maturity premium compensates investors for exposure to interest rate variations that affect all long-term stocks and bonds in the same way.
Find out the duration of the bond for which you are calculating the maturity risk premium. A bond's duration is the time, in years, that it takes for the bond to pay back the investor through its internal cash flows. For example, a bond that fully pays back an investor in 10 years has a 10-year duration.
Locate interest rate yields for risk-free securities. Visit the U.S. Department of the Treasury's Daily Yield Curve Rates page. The current yield rates are shown for treasury securities with maturities from one month to 30 years. Compare the yield for a treasury bond with a duration the same as your bond -- 10 years. Additionally, note the return for the same time period on a one-month treasury security.
Subtract the 10-year treasury security yield from the one-year treasury security yield to get the maturity risk premium. For example, as of the time of publication, the one-month treasury yield was 0.02. The 10-year treasury yield was 2.15. Subtracting one from the other has a result of 2.13. This represents the additional yield investors require in exchange for holding a bond to a 10-year maturity. The one-and 10-year treasury securities represent the most risk-free, stable return available and their rates serve as a benchmark to compare against riskier corporate bonds and other securities.
- Peking University; "Journal of Financial Economics"; Business Conditions and Expected Returns on Stocks and Bonds; Eugene F. Fama; Kenneth R. French; August 1989
- U.S. Department of the Treasury: Daily Treasury Yield Curve Rates
About the Author
Cynthia Hartman started writing in 2007 and has written for several different websites. She brings more than 20 years of experience in finance and business ownership. Hartman holds a Bachelor of Science in finance and business economics from the University of Southern California.