How to Calculate Liquidity Premium & Real Risk

by Steve Brachmann, studioD

Liquidity premiums and the real risk-free rate are two ways that an investor can determine how much of a return on investment they should expect for their money. Liquidity premiums are typically negotiated by investors who risk their money by investing in long-term debt or other highly illiquid assets. The real risk rate estimates the actual return earned when accounting for inflation. Because both calculations rely on future variables, the best an investor can do is find a close estimate through calculations.

Liquidity Premium

Find the daily yield curve rates published by the U.S. Department of the Treasury. These are available online at the treasury department's official website, In the left margin, click the link titled "Data and Charts Center." From the list that appears underneath, click the link titled "Interest Rate Statistics." Under the option "Select Type of Interest Rate Data" in the page that appears, select "Daily Treasury Yield Curve Rates" from the drop-down menu.

Find the Treasury yield curve rate that corresponds to the length of your investment. Treasury yield curve rates are published for one month, three months, six months, one year, two years, three years, five years, seven years, ten years, twenty years and thirty years as of the time of publication. The time period closest to the expected date of maturity on your investment is the rate you want to find the liquidity premium.

Find the off-the-run Treasury yield curve rate for the same maturity period. Off-the-run indicates an interest rate that has been previously issued and is not necessarily the same as the current rate, caused by economic changes. From the Interest Rate Statistics section of the U.S. Treasury's website, select one of the options under the drop-down menu titled "Select Time Period." Select a time period as far back from the current date as far as the maturity period of your investment goes into the future; if it's a 10-year bond, search for the interest rates 10 years in the past. If the investment's maturity period is as long as 10 years or more, you will be able to estimate a better liquidity premium by checking Treasury rates for multiple time periods over the previous 10 years.

Find the average of past Treasury yield rates and subtract the current rate from that average to estimate the liquidity premium of your investment. For example, say the current Treasury yield rate for a 10-year investment is 0.5 percent, and you've identified past Treasury rates for 10-year maturity periods of 0.8 percent, 0.9 percent and 0.7 percent. The average past Treasury yield rate for a 10-year investment would be 0.8 percent. Subtracting the current rate of 0.5 percent leaves you with an estimated liquidity premium of 0.3 percent on your investment.

Real Risk

Obtain the current Consumer Price Index (CPI) figure. This is calculated by the U.S. Bureau of Labor Statistics (BLS) through price surveys. Current U.S. BLS Consumer Price Index data can be obtained by visiting the Bureau of Labor Statistics website. Also, find the past CPI figure that corresponds to the length of the maturity period on your investment; for a 10-year bond, find the CPI for 10 years ago.

Calculate the inflation rate over the time period of your investment. This will not give you the exact inflation rate for the future, as that depends on many unknown variables, but it will give you a close approximation of what to expect. Subtract the current CPI from the past CPI and divide the total by the past CPI figure. Multiply the result by 100 to find the approximate inflation rate for that time.

Find the real risk rate, also known as the real risk-free rate, by subtracting the inflation rate from the current Treasury yield rate for the maturity period of your investment. This will give you an estimate of the actual rate of return on your investment that accounts for the rate of inflation.

About the Author

Steve Brachmann has been working professionally as a freelance writer since 2007. Hailing from Angola, N.Y., his work has been published in "The Buffalo News," SUNY-Fredonia's "The Leader" and on various websites. He is currently attending the State University of New York-Fredonia to earn a Bachelor of Fine Arts degree in acting with a communication minor.

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