The preceding analysis was based on the assumption that the maturity risk pre-
mium is zero. However, most evidence suggests that there is a positive maturity risk
premium, so the MRP should be taken into account.
For example, assume once again that 1- and 2-year maturities yield 7 percent and
8 percent, respectively, but now assume that the maturity risk premium on the 2-year
bond is 0.5 percent. This maturity risk premium implies that the expected return on
2-year bonds (8 percent) is 0.5 percent higher than the expected returns from buying
a series of 1-year bonds (7.5 percent). With this background, we can use the following
two-step procedure to back out X, the expected 1-year rate one year from now:
Step 1: 2-year yield MRP on 2-year bond 8.0% 0.5% 7.5%.
Step 2: 7.5% (7.0% X%)/2
X 15.0% 7.0% 8.0%.
Therefore, the yield next year on a 1-year T-bond should be 8 percent, up from 7 per-
cent this year.What key assumption underlies the pure expectations theory?
Assuming that the pure expectations theory is correct, how are long-term inter-
est rates calculated?
According to the pure expectations theory, what would happen if long-term
rates were notan average of expected short-term rates?Investing Overseas
Investors should consider additional risk factors before investing overseas. First there
is country risk,which refers to the risk that arises from investing or doing business in
a particular country. This risk depends on the country’s economic, political, and social
environment. Countries with stable economic, social, political, and regulatory systems
provide a safer climate for investment, and therefore have less country risk, than less
stable nations. Examples of country risk include the risk associated with changes in tax
rates, regulations, currency conversion, and exchange rates. Country risk also includes
the risk that property will be expropriated without adequate compensation, as well as
new host country stipulations about local production, sourcing or hiring practices, and
damage or destruction of facilities due to internal strife.
A second thing to keep in mind when investing overseas is that more often than
not the security will be denominated in a currency other than the dollar, which means
that the value of your investment will depend on what happens to exchange rates. This
is known as exchange rate risk.For example, if a U.S. investor purchases a Japanese
bond, interest will probably be paid in Japanese yen, which must then be converted
into dollars if the investor wants to spend his or her money in the United States. If the
yen weakens relative to the dollar, then it will buy fewer dollars, hence the investor
will receive fewer dollars when it comes time to convert. Alternatively, if the yen
strengthens relative to the dollar, the investor will earn higher dollar returns. It there-
fore follows that the effective rate of return on a foreign investment will depend on
both the performance of the foreign security and on what happens to exchange rates
over the life of the investment.What is country risk?
What is exchange rate risk?Investing Overseas 43Euromoneymagazine pub-
lishes ranking, based on
country risk. Students can
access the home page of
Euromoneymagazine by
typing http://www.
euromoney.com. Although
the site requires users to
register, the site is free to
use (although some data
sets and articles are avail-
able only to subscribers.)
Yahoo also provides
country risk evaluations at
http://biz.yahoo.com/ifc/.