Certified Financial Management Specialist Practice Exam

Which term describes the additional yield required for longer-term investments due to risk?

1. Nominal Risk-Free Rate

2. Maturity Rate Premium

3. Inflation Premium (IP)

4. Reinvestment Rate Risk

The correct answer is: Maturity Rate Premium

The term that describes the additional yield required for longer-term investments due to risk is the maturity rate premium. This premium compensates investors for the greater uncertainty and risk associated with longer time horizons. As the length of time for an investment increases, so does the potential for various risks, such as interest rate risk, inflation risk, and credit risk, which can affect the returns on a long-term investment. By demanding a maturity rate premium, investors ensure that they are compensated for these risks, which are less pronounced in shorter-term investments. This reflects the principle that as time increases, the exposure to risk increases, requiring a higher return to entice investors to lock up their funds for a more extended period. On the other hand, the nominal risk-free rate refers to the return on an investment with no risk of financial loss, typically represented by government securities. The inflation premium accounts for the effect of inflation on purchasing power but does not specifically address the risks tied to the investment horizon. Reinvestment rate risk pertains to the risk of having to reinvest cash flows at lower interest rates, which is not directly related to the yield demanded for longer-term investments.