2-10
FINANCIAL MARKETS AND INTEREST RATES
Measuring
risk premium
The risk premium is difficult to measure, but researchers have
identified two characteristics that serve as a reference:
1. Rate volatility Premiums are higher when interest rates
are volatile and uncertain.
2. Historical data The premium on 30-year U.S. Treasury
bonds generally has fluctuated between 1% and 2%, with an
average of about 1.7% for the last 60 years.
Short-term bonds are also subject to risk as a result of changing
interest rates. Most investors reinvest their funds as short-term
bonds mature and are paid off. If interest rates are falling, the new
bonds will pay less interest than the previously held bonds. This
reinvestment risk is of particular concern to investors living off the
proceeds of their investment.
Term Structure of Interest Rates
Relationship
between long-
and short-term
rates
The term structure of interest rates refers to the relationship between
long-term and short-term interest rates. Investors are concerned with
the term structure because it affects their investment preferences for
long- or short-term bonds. Corporate treasurers also must decide
whether to borrow by issuing long- or short-term bonds. We will
discuss how long- and short-term rates are related and what causes
changes in their relative values.
Yield Curve
Rates of return
plotted on a
graph
Interest rates on bonds of differing maturities are plotted on a graph to
illustrate their relationship. A graphic representation of the term
structure of interest rates is called a yield curve. "Yield" refers to the
rate of return on an investment. For our term structure study, the yield
of a security is the rate of interest paid on the security. The graph in
Figure 2.1 shows yield curves for two different U.S. Treasury
securities for two different dates. Remember, interest
rates are always changing.