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Although long-term bonds are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to...

Although long-term bonds are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to reinvestment risk. The maturity risk premium reflects the net effects of those two opposing forces. Explain.

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Answer #1

Long term bonds are exposed to interest rate risk because the prices of the long term bonds will be going down as the interest rates will be rising so there will be an inverse relationship between the price and the interest rate.

short term bonds are maturing and the principal must be reinvested so they are having a reinvestment risk and decline in interest rates will be mandatory necessitating reinvestment at a lower rate which will be resulting in decline in the interest income.

There is a maturity risk premium for investing into the long term bonds as maturity risk premium will mean that investors are sceptical about investment into higher maturity Bond because they will have high risk so there are always demanding a premium and hence, maturity risk premium is acting out as net effect of these two opposing forces.

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