174 Part 3 Financial Assets
which is higher the greater the years to maturity, is included in the required
interest rate.
The effect of maturity risk premiums is to raise interest rates on long-term
bonds relative to those on short-term bonds. This premium, like the others, is dif! -
cult to measure; but (1) it varies somewhat over time, rising when interest rates are
more volatile and uncertain, then falling when interest rates are more stable and
(2) in recent years, the maturity risk premium on 20-year T-bonds has generally
been in the range of one to two percentage points.^9
We should also note that although long-term bonds are heavily exposed to in-
terest rate risk, short-term bills are heavily exposed to reinvestment rate risk.
When short-term bills mature and the principal must be reinvested, or “rolled
over,” a decline in interest rates would necessitate reinvestment at a lower rate,
which would result in a decline in interest income. To illustrate, suppose you had
$100,000 invested in T-bills and you lived on the income. In 1981, short-term Trea-
sury rates were about 15%, so your income would have been about $15,000. How-
ever, your income would have declined to about $9,000 by 1983 and to just $2,700
by January 2008. Had you invested your money in long-term T-bonds, your in-
come (but not the value of the principal) would have been stable.^10 Thus, although
“investing short” preserves one’s principal, the interest income provided by short-
term T-bills is less stable than that on long-term bonds.Reinvestment Rate Risk
The risk that a decline in
interest rates will lead to
lower income when bonds
mature and funds are
reinvested.Reinvestment Rate Risk
The risk that a decline in
interest rates will lead to
lower income when bonds
mature and funds are
reinvested.SEL
F^ TEST Write an equation for the nominal interest rate on any security.
Distinguish between the real risk-free rate of interest, r*, and the nominal, or
quoted, risk-free rate of interest, rRF.
How do investors deal with in" ation when they determine interest rates in
the $ nancial markets?
Does the interest rate on a T-bond include a default risk premium? Explain.
Distinguish between liquid and illiquid assets and list some assets that are
liquid and some that are illiquid.
Brie" y explain the following statement: Although long-term bonds are heav-
ily exposed to interest rate risk, short-term T-bills are heavily exposed to rein-
vestment rate risk. The maturity risk premium re" ects the net e! ects of those
two opposing forces.
Assume that the real risk-free rate is r* " 2% and the average expected in" a-
tion rate is 3% for each future year. The DRP and LP for Bond X are each 1%,
and the applicable MRP is 2%. What is Bond X’s interest rate? Is Bond X (1) a
Treasury bond or a corporate bond and (2) more likely to have a 3-month or
a 20-year maturity? (9%, corporate, 20-year)(^9) The MRP for long-term bonds has averaged 1.4% over the last 82 years. See Stocks, Bonds, Bills, and In! ation:
( Valuation Edition) 2008 Yearbook (Chicago: Morningstar Inc., 2008).
(^10) Most long-term bonds also have some reinvestment rate risk. If a person is saving and investing for some future
purpose (say, to buy a house or to retire), to actually earn the quoted rate on a long-term bond, each interest
payment must be reinvested at the quoted rate. However, if interest rates fall, the interest payments would be
reinvested at a lower rate; so the realized return would be less than the quoted rate. Note, though, that reinvestment
rate risk is lower on long-term bonds than on short-term bonds because only the interest payments (rather than
interest plus principal) on a long-term bond are exposed to reinvestment rate risk. Non-callable zero coupon bonds,
which are discussed in Chapter 7, are completely free of reinvestment rate risk during their lifetime.