Introduction to Finance

maturity risk premium
is the additional expected return to compensate interest 
rate risk on debt instruments with longer maturities. 
Interest rate risk
is the risk of changes 
in the price or value of fi xed-rate debt instruments resulting from changes in market interest 
rates. There is an inverse relationship in the marketplace between debt instrument values or 
prices and market interest rates. For example, if market interest rates rise from, say, 4 percent 
to 5 percent because of the expectation of higher infl ation rates, the values of outstanding debt 
instruments will decline. Furthermore, the longer the remaining life until maturity, the greater 
the reductions in a fi xed-rate debt instrument’s value to a specifi c market interest rate increase. 
These concepts with numerical calculations are explored in Chapter 10.
The 
liquidity premium
is the additional expected return to compensate for debt instru-
ments that cannot be easily converted to cash at prices close to their estimated fair market 
values. For example, a corporation’s low-quality bond may be traded very infrequently. As 
a consequence, a bondholder who wishes to sell tomorrow may fi nd it diffi
cult to sell except 
at a very large discount in price. Possibly, this should be called an illiquidity premium since 
the premium is compensation for a lack of liquidity. However, it is common practice to use 
the term liquidity premium.
market interest rate 
interest rate 
observed in the marketplace for a 
debt instrument
real rate of interest 
interest rate 
on a risk-free debt instrument when 
no infl ation is expected
infl ation premium 
additional 
expected return to compensate for 
anticipated infl ation over the life of 
a debt instrument
risk-free interest rate 
interest 
rate containing only a real rate of 
interest component and an infl ation 
premium