Changes In Risk Premium Research Articles

The impact of macroeconomic announcements on risk, preference, and risk premium

This study examines the impact of macroeconomic announcements on the risk premium and its sources under time-varying preference. We propose a novel method to decompose risk premium changes into the risk and preference components, which are estimated from option prices immediately before and after the announcement using the Recovery Theorem. The results of the empirical analysis for the United States stock market indicate that (1) the negative (positive) macroeconomic announcement surprise increases (decreases) the risk premium; (2) the risk component mainly drives the increase (decrease) in the risk premium; and (3) the preference component has limited influence on the risk premium.

A Stock Return Decomposition Using Observables

We propose a method to decompose stock returns period by period. First, we argue that one can directly estimate expected stock returns from securities available in modern financial markets (using the real yield curve and the Martin (2017) equity risk premium). Second, we derive a return decomposition which is based on stock price elasticities with respect to expected returns and expected dividends. We calculate elasticities from dividend futures. Our decomposition is an alternative to the Campbell-Shiller log-linearization which relies on an assumption about the log-linearization constant. An application to the COVID crisis in 2020 reveals that risk premium changes drove much of the crash and rebound in the S&P500 while a fall in long-term real yields drove a strong positive return for 2020 as a whole.

Asset Variance Risk Premium and Capital Structure

AbstractThis article investigates how the asset-return variance risk premium changes leverage. I find that the premium reduces leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with the risk premium. Empirically, the model calibrations verify a significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I document that leverage correlates negatively with the variance premium. The highest negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premiums because their assets have high exposure to the market’s variance premium.

The Variance Risk Premium and Capital Structure

This paper investigates how the asset-return variance risk premium changes leverage. I find that the premium lowers leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with risk premium. Empirically, the model calibrations verify significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I also document negative correlation between leverage and the variance premium. The most negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premium because their assets have high exposure to market variance premium. JEL Classification: G32, G33, G12

Political Uncertainty and Commodity Prices

We study the effects of political uncertainty on commodity markets from both theoretical and empirical perspectives. Consistent with our theoretical predictions, commodity prices and inventories decline by 6.6% and 5.7%, respectively, and convenience yields increase by 1.9% in the quarter leading up to U.S. presidential elections, our proxy for political uncertainty on the demand side. Opposite results are obtained for political uncertainty on the supply side using national elections in major commodity-producing countries. We do not observe significant changes in risk premiums before elections. Furthermore, we show that gold is not an effective hedge against political uncertainty.

Market efficiency assessment under dual pricing rule for the Turkish wholesale electricity market

This study analyses the price dynamics of day-ahead and real-time electricity prices following the implementation of dual-pricing legislation in Turkey, to understand the legislation's impact on arbitrage opportunities and market efficiency. The convergence of prices between the day-ahead forward and the real-time markets analysed in order to determine whether persistent price differences between the two markets exist. Arbitrage opportunities exist if there is a persistent difference between prices in the day-ahead forward and real-time market. Markets are considered to be efficient if it is not possible for market participants to earn an excess profit through exploitation of price differences. Furthermore, we examined how the ex-post risk premium changes over time using rolling estimations and find that after the implementation of dual pricing, the risk premium increased significantly for day and peak hours where the demand is relatively higher compared to night hours. As market participants have more experience regarding the dynamics of the market, the difference between real-time and day-ahead forward prices converges to zero since the dual-pricing regime enforce market participants to forecast accurately by punishing the forecast error.

Time-varying risk aversion and return predictability

The risk aversion implied in option prices contains information about the attitude of investors toward risk and therefore its variation can capture the changes in risk premiums implicit in financial markets. In this paper, we propose a new method for estimating the variations of risk aversion and examine its predictability on future excess returns. Results for the S&P 500 index show that risk aversion has predictive power for future excess returns, even for short horizons that is, two- and four-week horizons and does not lose significance in the presence of conventional forecasting variables, including dividend yield, short rate, and variance risk premium. For robustness, we conduct an additional test on Sharpe ratio prediction and these results also support the predictability of time-varying risk aversion on future Shape ratio movements.

Impact of Macroeconomic Variables on Size and Book to Market Effects in Stock Returns: Evidence from Sri Lanka

The main purpose of this study is to find out whether size and BM effects are subsumed by macroeconomic variables in explaining variation in stock returns in Sri Lanka using stocks listed in the CSE. The sample covers the listed stocks from 1998 to 2013 that have information on share price, market capitalization and book value of equity. The macroeconomic variables considered for the study consist of change in expected inflation, unanticipated inflation, unanticipated change in term structure, unanticipated change in risk premium and growth rate in industrial production. Nine Size-BM portfolios are constructed each year for the purpose of analysis and Fama-MacBeth cross sectional regressions designed for various models over four holding periods ranging from one month to one year constitute the main test method. The results indicate that apart from semiannual holding period macroeconomic variables subsume size and BM effects in explaining variation in stock returns.

The overnight risk premium in electricity forward contracts

We analyze the risk premium on electricity forward contracts traded for the Nordic and German/Austrian electricity markets. We argue that finding risk premiums by analyzing overnight returns is more relevant than the frequently used ex post approach. The derivatives in these markets can be characterized as trading products and hedging products. Each contract shows a clear increase in trading volume and liquidity when approaching maturity. We link this to a testable hypothesis where financial traders are compensated for holding price risk, and where the sign and magnitude of the risk premium changes depending on the hedging pattern of producers and retailers. Incorporating this in regressions we find that there are higher risk premiums in the period before the forwards become front products, compared to the risk premiums in the front period. Quarterly and monthly contracts show the most significant results.

The Price of Risk in Sovereign Latin-American Debt: A Term-Structure Perspective

This study investigates the term-structure of sovereign emerging market yield spreads by decomposing it into the default risk component and the residual risk premium for Eurobonds of Mexico, Colombia and Brazil. We find that the risk premium tends to increase with maturity and account for the majority of the yield spread at all maturities for all three countries. The predominantly large, non-flat risk premium curve considerably modifies the yield spread term-structure which is implied by expected default losses. The risk premium and also its share within the yield spread both however vary considerably over time. The variation in risk premium changes is driven by common global and regional market risks. The relative impact of common market factors differs at short, medium and long maturities which is important in explaining risk premium dynamics that varies with bond maturity.

Understanding Term Premia on Real Bonds

Real bonds are a very important asset class and deciphering their risk-return relationship deepens our already extensive understanding about term premia. However, there has been little research on the dynamic behavior and economic determinants of risk premia on such bonds. This paper takes a series of steps towards extending extant evidence on nominal bond premia to their real counterparts. First, we document empirically that the real bond risk premium changes over time and fluctuates between positive and negative values. Second, we find that the real term structure itself contains a component that, albeit undetectable from cross section of bond yields, drives risk premia. Finally, we examine the potential link between the real bond premia and macroeconomic variables. We find that macro factors associated with real estate and consumer income and expenditure can capture a large portion of forecastable variations in excess returns on real bonds. Our empirical results indicate an essential need to propose asset pricing models such that implied real yields are able to account for these stylized facts.

What explains default risk premium during the financial crisis? Evidence from Japan

As is well documented, subprime mortgage markets carried significant default risk. This paper investigates the relationship between default risk premium, stock market conditions and macroeconomic variables during the financial crisis. Using iTraxx Japan Credit Default Swap (CDS) index spreads covering the period from March 2006 to November 2009, we employ a time-varying dynamic factor model with Markov regime switching to generate regime probabilities for default risk. We analyze the sensitivity of default risk premium changes to stock market conditions and macroeconomic variables by using two-state Markov switching models: a crisis regime sparked by rising loan defaults in the sub-prime mortgage market, and a non-crisis regime. We found strong evidence that the relationship between default risk premium changes, stock market and macroeconomic variables is regime-dependent. Our results suggest that during periods of crisis, CDS indices behave as a higher-risk indicator and become more sensitive to stock market conditions and macroeconomic variables. This paper examines the effects of the financial crisis in explaining the default risk premium. Understanding the determinants of default risk premium is important for financial analysts, economic policy makers and credit risk management.

Auswirkungen der IFRS-Umstellung auf die Risikoprämie von Unternehmensanleihen – Eine empirische Studie für Deutschland, Österreich und die Schweiz

Does an IFRS-adoption reduce the information asymmetry between firms and providers of debt capital and therefore the risk premium of corporate bonds? Contrary to prior empirical studies we examine the relationship between disclosure and cost of capital for debt financing. We analyse the impact of an IFRS-adoption on the risk premium of German, Austrian, and Swiss corporate bonds between 1997 and 2005. Our results indicate that the change in risk premium declines after an IFRS-adoption by 40%. However, the effect occurs with a time-lag.

What the Libor-OIS Spread Says

T he term London interbank offer rate (Libor) is the rate at which banks indicate they are willing to lend to other banks for a specified term of the loan. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate. (In the United States, the overnight rate is the effective federal funds rate.) In such a contract, two parties agree that one will pay the other a rate of interest that is the difference between the term OIS rate and the geometric average the overnight federal funds rate over the term of the contract. The term OIS rate is a measure of the market’s expectation of the overnight funds rate over the term of the contract. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other. The term Libor-OIS spread is assumed to be a measure of the health of banks because it reflects what banks believe is the risk of default associated with lending to other banks. Indeed, former Fed Chairman Alan Greenspan stated recently that the “Libor-OIS remains a barometer of fears of bank insolvency.” He then noted that “that fear has been substantially reduced since mid-October, but the decline has stalled well short of any semblance of normal markets,” suggesting that the still-high Libor-OIS spreads were an indication of problems in the banking industry. There is no doubt that changes in the LiborOIS spread reflect changes in risk premiums rather than changes in liquidity premiums— premiums that reflect banks’ desire for liquidity: The difference between the rate on term certificates of deposit (CD) and the equivalent-term Libor rate is very small. If banks were liquidity constrained, borrowing banks would have to pay a higher rate when they borrow from each other than when they borrow in the CD market, where lenders are not “liquidity constrained.”

Aggregate Mutual Fund Flows and Subsequent Market Returns

This paper re-examines the relation between aggregate US equity mutual fund flows and the equity market returns in subsequent periods. Investigating aggregate monthly data in the years 1984-2003, we find a positive contemporaneous relation between flows and returns. This price change is partially reversed in the following nine months. The negative relation between flows and subsequent returns is consistent with risk premium changes that are negatively related to price changes and it causes mutual fund investors, as a group, to realize a long-term accumulated return that is lower than the long-term accumulated return on a buy-and-hold position in these funds.

What Explains the Industrial Revolution in East Asia? Evidence From the Factor Markets

This paper presents dual estimates of total factor productivity growth (TFPG) for East Asian countries. While the dual estimates of TFPG for Korea and Hong Kong are similar to the primal estimates, they exceed the primal estimates by 1 percent a year for Taiwan and by more than 2 percent for Singapore. The reason for the large discrepancy for Singapore is because the return to capital has remained constant, despite the high rate of capital accumulation indicated by Singapore's national accounts. This discrepancy is not explained by financial market controls, capital income taxes, risk premium changes, and public investment subsidies.

FIML estimation of the dollar-deutschemark risk premium in a portfolio model

This paper tests the null of a constant risk premium against an alternative where the risk premium changes with regimes. The reduced form equations for the spot rate and the net supply of foreign assets are derived from a portfolio model and a flow equation for the current account. Regime changes alter the spot rate forecast variance and consequently change demand elasticities and reduced form parameters. Using data for 1964-83 and permitting regime changes in 1969, 1973, and 1979, we fit our model with FIML to impose all the theoretical restrictions. In some specifications we find evidence for risk aversion.

Zur Versicherung anomaler Risiken

For policies concluded to cover abnormal risks this essay demonstrates by means of some examples the development of the premium reserves, the changes in risk premiums if the sums assured are reduced and the supplemental premium reserve payments in those cases in which there is a reduction of the term of assurance. The essay also describes the process allowing the simple addition of two assurances with different excess mortality to give a single assurance. Finally the author shows that a policy concluded to cover an abnormal risk and providing for repayment of the risk premium at the end of the endowment period if the insured is then living bears the characteristics of an assurance payable in case of death if the risk premiums increase with increasing excess mortality.