What is Risk premium?
It is the extra return that is offered to someone with cash to purchase an asset with market risk. Cash can be spent today. Cash can be used to pay off debt today cash can be saved today in a bank or mattress or a money market fund.
An asset that has market risk is not cash. When purchased today it can change in value tomorrow while cash won’t change. The reason why assets require a higher expected return is because of this feature/bug. How can all assets have a risk premium when some assets go up and some go down each day/month/year? This is a good thing question. It’s about expectations.
At this very moment, all assets have a risk premium. Every asset is currently owned by someone and they think it will go up. We can’t know which assets will go up. If we did everyone would move to those assets and push up the price. But as of this very moment, all future expectations for assets are priced in for this discussion. Sure, some assets will go up and some will go down based on changes in fundamental economic outcomes and expectations of changes. But what is important is that despite the moves things that go down, go down less, and things that go up, go up more because they collect risk premium.
How much risk premium does each asset get? Firstly it depends on the riskiness of the asset. The less market risk the less risk premium. A one-year treasury will have very little risk premium and a meme stock will have a lot. The simple concept is that all assets should have the same risk-adjusted return.
In other words, a higher-risk asset should have a higher risk expected return than a lower-risk asset. The expected return should scale linearly with the risk. If this was not true and one could generate a higher risk-adjusted return in specific assets money would flow into the asset arbitraging away the excess.
It is important to realize that all assets have a return that is greater than the return on cash because they carry market risk and no one would purchase them with cash if they had a negative expected return vs cash So far I have stated that all assets have a risk premium and that risk premium scales with market risk and that the expected risk-adjusted return of all assets is the same.
Before I address what influences the level of risk-adjusted return I’ll mention what I mean by risk. What I mean by risk is amorphous. I don’t have a good answer. It is some combination of future expected volatility and future drawdown risk. But I don’t really know so it’s just a concept for now.
So I have said that all risk-adjusted returns are the same. But what drives that level of risk premium. This is the Second big concept and in today’s world is by far the most important.
The level of market-wide risk premium is driven by the availability of cash (money and credit) vs the supply of assets. (Which includes real and financial assets). When cash is plentiful and issuers of debt and equity need very little cash. Risk premiums tend to be low. When cash is tight and/or issuers are looking to sell a lot of debt and equity risk premiums tend to be high. For you equity guys. A risk premium is inverse to multiples. Higher risk premiums equal lower multiples. For you credit gals risk premiums are directly related to credit spreads. Rates guys. Risk premiums are embedded in both real rate products and nominal rate product yields So when I track risk premiums I focus on both the availability of money and credit availability, including Fed purchases and the supply of assets which includes government debt. Also importantly who gets the cash when debt or equity is issued and what do they do with it
My synthesis of the current environment is that despite the future slowing of bond prices by the fed the government handouts are working through the system and will replace some of the tapers and compress risk premiums or at a minimum keep them steady over the next 6 months or more The big risk for a major risk premium expansion would be a Fed balance sheet roll down and or an unpaid for Government spending plan.