Maturity Risk Premium
This concept is generally applicable for bonds. The maturity risk premium is a premium to investors for holding bonds for a longer duration. The maturity risk premium calculator is an online aid in the calculation of such a premium.
There is always a possibility of increment in the interest rate before the maturity of bonds. Suppose, an investor buys a bond at an interest rate of say 2% for 5 years. And, at the time of maturity, the rate increases to 3.15%. Here, the issuer will only pay the pre-decided rate of interest to the investor which is less than the actual interest rate prevailing in the market. This risk is interest rate risk.
The maturity risk premium offsets this interest rate risk by increasing the rate on long-term bonds.
Maturity risk premium can be obtained by deducting Treasury bill yield from an interest rate of the bond. To put it mathematically,
Maturity Risk Premium = Interest Rate of Bond – Treasury Bill Yield
About the Maturity Risk Premium Calculator
The user is required to enter the following numbers into the calculator and with a simple click, it will calculate the result instantly.
- Interest rate of bond
- Treasury bill yield
How to calculate using Calculator
The following inputs are to be provided to the calculator
Interest Rate of Treasury Bill
It is the rate of interest applicable on the bond in which you have invested for n number of years plus the year of maturity.
Treasury Bill Yield
It is the rate of one year to determine the maturity risk premium for making an investment for n number of years.
Assume the yield of a year Treasury bill is 0.71% and the interest rate on a 10-year Treasury bill is 2.41%.
Maturity Risk Premium = 2.41% – 0.71% = 1.71%
Now, in order to make a decision on whether to buy a bond or not, you have to calculate the required rate of return. Suppose, we need to calculate the required rate of return of 13-year bonds. The formula for getting a required rate of return is adding default risk premium, liquidity risk premium (along with maturity risk premium) and the risk-free rate.
Here, risk-free rate = 1.2%
Liquidity risk premium = 0.7%
Default risk premium = 0.5%
For calculating maturing risk premium of a 13-year bond, the yield of 13 years is to be subtracted from that of 10 years as we are already considering the risk-free rate of a 10-year bond. Let’s assume the maturity risk premium of the 13-year bond to be 1.21%.
Hence, required rate of return of 10-year bond = 1.2% + 0.7% + 0.5% + 1.21% = 3.61%
Therefore, if an investor wishes to make an investment in 13-year bonds, he/she should undertake such investment only if the interest rate on the bond is equal to or more than 3.61%.