Estimating Risk Premiums for One-Year Treasury Bills

Even safe investments, like T-bills, carry a risk premium.

Even safe investments, like T-bills, carry a risk premium.

Couples that seek low-risk investments should consider investing in government securities, such as U.S. Treasury bills or T-bills. Investments in Treasury bills provide a rate of return that is considered risk-free. That's because there is very little chance that the government will default on its interest and principal payments. However, you will also find that the complete absence of market risk does not exist and even safe investments will have even a small risk premium added to their rate of return.

Risk-free Rate of Return

The risk-free rate of return is the interest earned on an investment considered to have nearly zero risk. It represents the minimum return an investor should earn in the market. U.S. government securities are considered the safest investments in the market and the return on short-term Treasury bills are usually used as a benchmark to compare the return to other riskier investments and to evaluate their risk premium. To estimate the risk premium, you can use the three-month rate on the U.S. Treasury bill.

Investor Compensation

The purpose of the risk premium is to compensate investors for investing their money in securities with various risk profiles. Low-risk investments carry a very small risk premium and high-risk investments must reward investors with a high-risk premium. A one-year Treasury bill is considered a low-risk investment with a slightly higher risk profile than the three-month Treasury bill, mostly due to the security’s longer duration.

Risk Premium Components

A risk premium is composed of several components and takes into account an investment’s business risk, financial risk, liquidity risk, exchange-rate risk and country-specific risk. Your investments, including one-year Treasury bills, carry a risk premium that takes all of these factors into account to assign a reasonable market return to the investment. Since a treasury bill is issued and guaranteed by the U.S. government, the risk premium’s components have little effect, if any, on the T-bill’s overall risk premium.

Risk Premium Calculation

Calculate your T-bill’s estimated risk premium by taking the one-year bond’s interest rate and subtracting the rate for the three month T-bill. The result is the approximate risk premium on your investment. Let’s use a real world example to determine a T-bill’s risk premium – on May 1, 2012, the rate on the one-year T-bill is .19 and the rate on the three-month T-bill is .09. The estimated risk premium is .10, or .19 subtracted by .09.

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