Term premium

The extra yield investors demand for holding a long bond rather than rolling over short ones, above expected future short rates. It tends to rise with maturity and with inflation uncertainty.

Where you will meet it

Term premium appears in 4 learning outcomes on the CFA syllabus. A few of them:

• Explain the traditional term structure theories and set out what each one implies for forward rates and for the yield curve's shape
  CFA Level II · Fixed Income

  “Liquidity preference adds a positive term premium that rises with maturity, so forwards overstate expected rates and a mildly rising curve can accompany flat expectations.”

• Read the yield curve's slope as a signal about the economy, and explain how it reflects the combined stance of monetary and fiscal policy
  CFA Level III · Asset Allocation

  “Short rates track the central bank, while long rates embed expected future short rates, inflation expectations and a term premium affected by government borrowing.”

• Explain how major economic drivers feed into a view on spreads, benchmark rates and shifts in the yield curve
  CFA Level II · Fixed Income

  “Long yields reflect expected average short rates plus a term premium that rises with inflation uncertainty and heavy government borrowing.”

• Set out the methods for estimating expected returns on fixed income
  CFA Level III · Asset Allocation

  “The building block approach sums a short-term default-free rate, a term premium, a credit premium and a liquidity premium, each estimated with reference to the cycle and current spreads.”

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

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