Premiums demanded by investor over risk free rates, 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.

Fixed income duration risk premiums and sovereign risk premiums from historical perspective since 1991 are discussed below.

Sovereign risk premium –

  • Sovereign risk premium goes up when investors demand added yield perceiving a country might not fulfil the claims of creditors. Risk premium supposed to remain close to zero as countries are considered to be the safest to lend. Historically that have not been the case.
  • During early 1990’s Russian default that led to India’s and other sovereigns, premium shot up to 6%.
  • Rose to similar highs during Asian currency crisis of late 90’s.
  • Premium has remained close to zero level since 2000 to 2009. Economic boom and credit growth was part of this stable period.
  • Post 2008 financial crisis, premium rose in anticipation and peaked during sovereign debt crisis during 2011/12 around 5%.
  • As of now, Central bank’s massive asset purchase have pushed yields closer to zero percent.

It would be interesting to observe the premium once these assistance are withdrawn. Without stability in this premium Euro zone might not have good old days back.

Fixed income duration risk premium –

  • It explains investors ease over longer horizon. Value of the bond remain a concern for inflation as lower inflation or lower rates might erode the value. Unstable economic conditions also gets pictured in the premium.
  • 2000 credit bubble led this premium jumped to negative, however rose sharply since the crisis.
  • Period of bubble in late 2006/07 pushed the premium once again lower close to zero.
  • At the peak of the crisis, investors demanded 3.5% extra premium for duration.

Since the crisis, as of 2015 investors continue to remain cautious over long term demanding higher premiums compared to historical level in a low inflationary environment.

The material has been provided by InstaForex Company –