Thursday, December 2, 2010

"Risk Premium" makes the big time!

In yesterday's Wall Street Journal, Marcus Walker and Brian Blackstone's "Europe's Crisis Widens" article includes the following text: "Bond markets across Europe's vulnerable fringe sank, as the 'risk premium' investors demand for lending to Spain and Italy hit record highs." I was pleased to see the use of the term "risk premium," which the authors felt compelled to place in quotation marks but failed to explain. Perhaps they (understandably) felt that anyone who was unfamiliar with the expression could easily "Google" it and uncover a massive amount of information.

We include discussions on this topic in our Fundamentals of Investment Performance course, and so this article will be a reference in the future, as it points out how the market can demand higher interest rates when its concerned with an issuer's solvency. In this case, we're speaking of countries within Europe who are having difficult times.

Are these debt issuers obligated to increase their payments on already issued bonds? No, the bond prices will fall in order to provide purchasers with a higher effective yield on their investment; those who hold the debt will, of course, see the value of their portfolios drop as a result. And going forward, as these countries issue new debt, they will likely see a demand for higher rates, which will, of course, mean higher costs to their country. The article also points out that the rating agencies are beginning to consider downgrades; interesting that the downgrades aren't leading the way, but are in response to the market's demands for higher yields to compensate for the higher perceived risks.

While the issue of "risk premiums" has, at times, come under attack, the reality is that we find this concept in numerous places, including the Sharpe and Treynor ratios, and Jensen's alpha. And some fixed income attribution models employ the premium to calculate the "spread effect."

If we can obtain a certain return for virtually no risk, we should be entitled to a higher interest rate if we're going to invest in something that has a higher risk; thus the risk premium.

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