Risk and Rates of Return d.

Liquidity Premium (LP) – premium added

Risk and Rates General Rule of Thumb:
More Risk = More Returns
Less Risk = Less Return
It depends on the investor:
• Risk Seeking – prefer high risk investments
because wants to have high returns
• Risk Neutral – indifferent to the degree of risk
involved in an investment
• Risk Averse – conservative, unwilling to take on
high risk investments unless the returns justify
and compensates for the high risk taken
to the rate of a security based on how
quickly the security can be converted back
to cash near to its original cost
e. Maturity Risk Premium (MRP) – premium
that reflects interest rate risk. Securities
with longer maturities have greater
interest rate risk
f. Nominal Risk Free Rate (RFR) – interest
rate on a security that has absolutely no
risk at all although no securities are
completely risk-free
- 1 year approximate rfr=r*+IP
- 1 year accurate rfr=[(1+IP)] – 1

Different Kinds of Risks

• Credit Risk – resulting from a borrower’s failure

to pay a loan or meet contractual obligations
- Example: the store was bankrupt
• Political Risk – risk than an investment’s
returns could suffer because of political
changes or instability in an economy
- Example: Invest stocks in Australian
company and experience political thermal
• Interest Rate Risk – there will be a decline in
the vale of a security resulting from
unexpected fluctuations (rising interest rates)
in interest rates. It is the opposite of
reinvestment rate risk
• Market Risk – systematic risk and non-
diversifiable risk. Occurs from the
characteristics of an entire market or asset
class

Determinants of Market Interest Rate

• Factors affecting interest rate are called

determinants of market interest rates. These
include:
a. Real risk-free (r*) – exist on a riskless
security if no inflation were expected or
when inflation is zero during the
investment period. It is the rate of interest
from riskless government securities in the
absence of inflation
b. Inflation Premium (IP) – increase in the
price over time. When calculating IP, use
the projected average inflation over the
life of a security
c. Default Risk Premium (DRP) – a borrower
will default on a loan (not pay the principal
and interest). Government issued
securities will have zero DRP.
• Treasury – from government
Corporate – from companies
• Short-term – mature in a year
Long-term – mature longer than a year
Short-term Treasury
• IP – because inflation is a reality of life; prices
will always change every time
• MRP – because they mature in 1 year or less
• DRP – government will not allow its financial
instruments to default because they need to
preserve the country’s reputation
• LP – easily convertible to cash means can be
easily sell
Long-term Treasury

• No DRP and LP but includes IP and MRP

because it takes more than 1 year to mature

Short-term Corporate

• No MRP because it will mature in 1 year

however, DRP because its possible to
corporations to experience difficulties and pay
off their debts. LP is also included since it is not
easy to dispose or convert corporate security
into cash compare to treasure securities

Long-term Corporate

• Possible for long-term securities to be

defaulted and take some time to sell corporate
securities (riskier)

Yield curve and the term structure of interest rates

• Yield curve - a graph of the term structure

• Term structure – relationship between interest
rates (or yields) and maturities
• Upward slope due to an increase in expected
inflation and increasing maturity risk premium

How to compute for the inflation premium and

maturity risk premium

• Determinants of market interest rates:

a. Real risk-free rate (r*)
b. Inflation premium (IP)
c. Default risk premium (DRP)
d. Liquidity Premium (LP)
e. Maturity risk premium (MRP) What is the relationship between the Treasury
- Black – the values are given Yield Curve and the Yield Curves for corporate
- Red – the values are not always given or issues?
may require derivation
• Find the average expected inflation rate over • Corporate yield curves are higher than that
years 1 to n: of Treasury securities, though not
𝑛 necessarily parallel to the Treasury curve
∑ (𝑛𝑘)𝐼𝑁𝐹𝐿𝑡
𝑡=1 • The spread between corporate and
𝐼𝑃𝑛 =
𝑛 treasury yield curves widens as the
corporate bond rating decrease