Basics of Corporate Finance

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.