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Premiums demanded by investor when investing in a particular asset class. Risk premiums are of high importance, as small changes in risk premium demanded by investors, might lead to rally or sharp selloffs in particular asset class.
Credit risk premiums and Equity risk premiums from historical perspective since 1991 are discussed below.
Credit risk premium -
- Credit risk premiums are associated with fixed income securities, usually goes up when investors fear that bond issuers will not be able to pay the money back.
- Historically speaking, Credit risk premium has stayed close to 2% historically, however rose close to 3% during dot com bubble era.
- Most rise was recorded during 2008 financial crisis, that saw premium demanded move to 7.5%
- However Premium has moved back close to 2% level by 2015.
Rally in asset classes are the result of risk premium dropping to normal level. However investors should remember mispricing of the premium during credit boom of 2006-07 when premium dropped close to 1%.
Equity risk premium -
- Historically equity risk premiums had been higher than credit risk premiums. 2-3% is much more stable level for Equity risk premiums historically speaking.
- Stock market crash in Japan led risk premium to hit above 3% level.
- Excessive risk betting in US tech stock in late 90's led risk premium to drop to 1% and below credit risk premium that finally ended with tech bubble bust.
- During 2008 financial crisis equity risk premium shot up close to 6.8%, which dropped sharply after FED reserve announced QE.
However since 2008 great recession and 2011 Eurozone debt crisis, Equity risk premiums have stayed above levels that can be called normal. As of end 2014, Equity risk premium is close to 6%. It would be fair to say, investors still judging equities as quite risky and recent rally is fuelled by lowering real rates by Central banks.
Equity risk premiums might drop once global growth engine start firing all cylinders.
To note every percentage point drop in risk premiums equities might rally 17-20%.
