Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Thu, 13 Apr 2006

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.

Posted at 15:26 on Thu, 13 Apr 2006     View/Post Comments (0)     permanent link