This financial indicator represents the additional cost a country or company must bear to get the financing it needs. The less confident investors are, the higher the premium will be.
The risk premium is particularly important in times of economic uncertainty.. Confidence being is a key concept in order to understand how this economic indicator works. We can explain this to you with a very clear example. Imagine two businesses that require financing. One attracts more customers every day and has no significant debts, enough revenue to cover its expenses (and profits every month), and an owner who looking for an investor to open a second location. The other business still hasn't been able to grow its customer base and has overdue debts with suppliers, higher expenses than revenues and an owner in need of funding to clean up the its accounts. Which of these the two businesses inspires the most confidence? With which Where do you think your an investment would be riskier?
The owner of the first business will probably have no problem in finding the financing under good terms.. However, the owner of the second business will need to offer a higher financial “reward” to pursuade investors to take a risk. This surcharge the owner of the second business must pay is a risk premium.
What is a country’s risk premium?
To raise money, countries issue public debt to get it from people, companies and other countries. However, if investors aren't confident about in the country’s economy, the country will have a harder raising money and need to give investors a higher return to make the risk they're taking on more attractive.
Amid economic uncertainty, investors know that an indebted country asking for more money to pay expenses will have more trouble to repay those resources. That i's why they tlend at a higher rate.
How is the risk premium calculated?
The risk premium is difference between the interest rates paid by a one country and another with sounder finances and a stabler economy. Because Germany's economy is the stablest and least risky Europe, it pays the lowest interest rates and its 10-year bund (bond) is considered the regional benchmarkand. Finally, the difference in interest rates above is multiplied by 100 to express it in basis points. Let’s look at an example.
If a country pays investors an interest rate of 4.5%, and Germany pays 1%, we subract Germany's interest from the other country's concerned: 4.5% - 1% = 3.5%. Then we multiply it by 100. Thus, the country’s risk premium would is 350 basis points (3.5 x 100). In general, a risk premium between 0 and 400 basis points is considered normal. But it's above 400 points, it's too too high and the country's economy of the country is compromised and needs intervention.
We can calculate a company's risk premium similarly by subtracting its interest rate from a benchmark (e.g., the interest rate of the most profitable company or an entire sector, or the state's cost of debt.
How does a higher risk premium affect consumers?
If the risk premium rises, investors are doubtful about a country’s ability to repay its debts.
The higher interest rate makes it more expensive for a country to raise money, as it pays a higher interest on its debt. This forces the government to make major adjustments, like spending cuts and to tax hikes to raise its revenue. This can cause the economy to lag, which can affect employment, investment, prices, consumption, wages, etc.