Varying Risk Premia

Following up from my previous post on the riskiness of Americans versus Europeans, is this article from the same issue of the Economist varying returns between stocks and bonds:

IF BOND and stockmarkets are driven by the economy, they should tell similar stories. American two-year government bonds are yielding around 2%, suggesting a dismal economic outlook. Similarly, corporate bonds are trading as if many of them are expected to default. So why are global stockmarkets, after a wobbly January, acting as if they had barely heard of the credit crunch?

The answer lies in the fact that there were so many financial instruments that were essentially bets on debts being paid off which failed. People who bought these instruments want to sell them, but no one will buy, so prices are falling.

The most plausible reason for the different moods lies in the structure of the world of credit. The debt markets, as everyone knows, indulged in a lending spree in recent years. Investors, desperate to earn higher returns, were happy to buy complex (and often risky) products. Those bets are now unwinding and, as a result, the credit markets have become trapped in a negative spiral. The need to reduce risk forces investors to sell assets into an illiquid market. Those firesales drive down prices which, in turn, prompts more investors to reduce risk.

But what is of most interest to us, is when it comes  the risk premium, we assume that people who are more risk-averse would prefer to buy bonds (or bond-related financial instruments), and people who are risk-loving would prefer to buy stocks. But what happens when people who bought these instruments are now dumping them? The risk premium is changing.

So – another paper topic idea for those who are interested. In what situations would a risk premium change? What countries and/or time periods in a particular country have seen this sort of change happen? What preceded it? And what caused it?

As for the Economist article,  the answer is: It depends on the banking industry.

This deleveraging [selling the loan-backed securities] is the classic response of investors when they become risk averse. But it is being made worse by the turmoil among banks. Before the subprime crisis, it was widely thought banks had succeeded in dispersing risk. Now the risk has come back to haunt them.


But there is an industry where the markets move as one. The credit crunch has caused the cost of insuring against bank defaults to rocket. Since the start of August, the banks have underperformed the global stockmarket by 12%. Everyone agrees that the fortunes of the banks will decide the length and depth of the crisis.

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