Saturday, January 9, 2010

Reversal in Risk Premiums (or premia): The 2010 story

The big story from the 2010 updates is that that risk premiums across the board have reversed the rise that we saw during the crisis. The broad based nature of the shift can be seen by looking at the following:

a. Equity Risk Premiums: I have been tracking the equity risk premium at the start of every month since the start of the market crisis on September 12, 2008. On that day, the equity risk premium for the US was 4.37%. That number exploded to almost 8% in November 2008 and settled in at 6.43% at the start of 2009. In the first three months of 2009, the equity risk premium continued to rise (to more than 7% in early April 2009). Since then, though, the equity risk premium has dropped dramatically. On January 1, 2010, the equity risk premium was down to 4.36%, roughly where it was at the start of the crisis. If you are interested in the computation, download the excel spreadsheet that I used (and feel free to modify and adapt it as you see fit)

b. Bond default spreads: The market crisis had its origins in easy lending, reflected in the low default spreads that we saw for different bond ratings classes in late 2007. Bond default spreads almost tripled during 2008, thus outstripping the change you saw in equity risk premiums. In 2009, however, bond default spreads returned to pre-crisis levels. You can get to my latest estimates of default spreads by clicking here.

c. Sovereign spreads: When the market crisis unfolded, emerging markets were affected more adversely than developed markets, as manifested in collapsing stock prices and soaring sovereign default spreads. The default spread for Brazil in the Credit Default Swap mark rose to 7% in November 2008. Those spreads have decreased to pre-crisis levels (and below, for some markets). Brazil's CDS spread in January 2010 was hovering at about 1.5%.

While I am not surprised that risk premiums have come down, I am surprised at how quickly they have reverted back to old levels. In early 2009, my prediction would have been that equity risk premiums by the end of the year would be down to about 5%. At one level, the speedy recovery in risk premiums can be considered to be evidence of mean reversion- that markets quickly revert back to historic norms even after major crisis. At another level, the quick adjustment can be viewed as a sign of a market that is in denial. My gut feeling is that the market has gone up too far, too fast and that equity risk premiums will correct themselves over this year and move back up towards 5%, but I may very well be wrong again.


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  2. Prof,

    When you say that the risk premiums reversing so quickly could indicate a market in denial, isn't the reverse possible too? Could the market have been overly skeptic after the September of 2K8? Because if you look at things very fundamentally, the crisis was really a financial markets crisis rather than an economic downturn (with demand or supply levels for any conceived basket of goods not as alarmingly out of sync). So default spreads and sovereign risk premiums (mainly for emerging markets) probably climbed much higher than they would have, had the markets been able to discern between the real business growth potential and the potential for making money purely in the financial markets.

    Could this be true? Because then, risk premiums reversing so quickly only proves that the efficient market hypothesis has prevailed, eventually, after a 15 month period.

    Am I making any sense?

  3. As I mentioned in the post, I don't know. It could be that markets over reacted in later 2008 to a banking problem or that they are under reacting now to a changed risk environment. This year should deliver some answers.

  4. Hi Prof,

    While on the topic of ERPs and their trends, I wanted to know your thoughts on the Equity Premium Puzzle.

    For one, I didn't understand what the puzzle exactly was. Secondly, I am not sure if the solutions proposed to explain the puzzle, are not in violation of empirically proven laws of risk and return. However, I found the topic to be very contentious among the academic community and so had to know your take on it.

    Hope you oblige!

  5. Prof,

    I wanted to know your thoughts on a recent article by Prof.Shiller in which he talks abt Hybrid securities as a solution for avoiding future credit crisis like the one we witnessed last year.

    "Regulatory hybrid securities would raise the cost of capital to banks (because creditors would have to be compensated for the conversion feature), whereas the banks would rather rely on their “too big to fail” status and future government bailouts. " - Is this as simple as it sounds?

  6. Unlike Professor Shiller, I don't think hybrid securities will provide a solution to the fundamental mismatches between inflow and outflow that bedevil all human beings (and thus create risk).

    I do find it interesting, though, that Professor Shiller, with his strong views on market irrationality and exuberance, is such a strong proponent of a market-based solution.

  7. Sorry, but you cannot evaluate market risk premium in this way. You would have to know investors are predicting about the economy as a whole and the long-term direction of the stock market.

    Market risk premium is only one factor in a stock's valuation. An investor's expectations of future cash flows is another. I may have the same risk tolerance the whole time (and hence the same market risk premium), but if I see news showing the recession is going to last much longer, then the valuation of my stocks drops as well.

    Simply plugging in market valuations and dividends does not yield a market risk premium.


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