Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Have risk premiums declined?

The IMF’s Global Financial Stability Report, April 2006 has a
discussion about risk premiums (Box 1.2) which states

There is a widely held view that investors’
appetite for risk has increased over the past few
years, leading to higher prices for risky assets
and narrower spreads on credit and other risky
products. … However, the
analysis here suggests that investors’ overall attitude
toward risk appears not to have changed appreciably

Basically, the IMF says that that while the credit risk premium
seems to have declined, there is little change in the equity risk
premium. Therefore, on balance, the IMF seems to say there is no
evidence of under pricing of risk.

This conclusion is problematic for several reasons. First the
evidence on falling risk premium is not based only on a declining credit
spread. The term structure spread also has a large risk premium
component and this component appears to have declined
sharply. Similarly, there is surely some evidence that currency risk
premiums have declined. Some observers are even talking of the end of
‘original sin’. So even if we accept
the claim regarding stable equity premium, I would think that the
score is 3-1 in favour of a decline in premium rather than the 1-1
draw that the IMF seems to portray.

But even the claim regarding the equity risk premium has to be
taken with more than a pinch of salt. First, equity risk premiums
declined sharply in the late 1990s and even an unchanged premium is
still quite low by longer historical standards. Second, the estimate
of risk premium is based on the earnings yield without any adjustment
for growth. Most discussions on over pricing of equity today emphasize
the apparent disconnect between the high growth expectation embedded in
current valuation and the low long term interest rate. Thus any
discussion of equity risk premium that treats the earnings yield as
the return on equity simply misses the point.

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