A term premium is a rate of return on an asset that provides an incentive for investing in that asset even though it is a long-term investment that may also be illiquid in nature. In a situation where an investor is evaluating two similar assets but one matures later than the other, the one that will take longer to mature may be accompanied with a term premium. If it is not, the investor will be more inclined to take on the short term investment because it will generate a profit more quickly and the investor's money will not be locked up for an extended period.
In a graph of a yield curve showing the types of yields provided by different kinds of investments, it can be noted that long-term investments tend to yield more. This is the result of the term premium; these investments must yield more, or investors will not find them appealing. Variations in the yield curve appear in response to economic pressures such as a recession, slow movement in the investment field, and other factors.
From the point of view of an investor presented with two identical investments of different term lengths, the short term investment will be more appealing. It allows the investor to make money and then move on, freeing up capital for other ventures. Thus, investors demand a term premium for long term investments, to provide them with a reason for investing in such bonds and other securities.
This concept is also related to a liquidity premium. The more liquid an investment is, the easier it is to transfer or sell. Liquid assets appeal more to investors. When an asset is illiquid, investors may expect to be offered a liquidity premium as a form of compensation. The company offering the investment offers a premium that is designed to entice investors without compromising the investment instrument.
Investors are more likely to take risks on short term investments because they believe they can make more accurate predictions about the direction of the market when forecasting in the short term. As a result, in addition to coming with a higher rate of return in the form of a term premium, long term investments also trend toward the less risky side. Investors are less inclined to take a chance on a risk which they will have to worry about for 15 or 20 years than a risk which will be a concern for six to 18 months.
