What is the risk premium?
premium is the greatest return an investor demands of an asset for undertaking the risk it entails, compared to another asset considered risk-free.
The risk premium is generally known as an indicator of the solvency of a state and of the confidence of investors in the solidity of its economy, expressing the cost of financing itself by issuing public debt in comparison to a benchmark country (in our case, Germany). The risk premium, however, can also be applied to debt issued by private enterprise.
The greater the risk of a country with respect to another country, the greater its risk premium, and also the higher the rate of interest it will pay to borrow money.
How is the risk premium calculated?
To calculate a country's risk premium, the interest rate offered by the country on purchases of its government debt (generally the 10-year bond) is subtracted from the interest rate offered by a reference country.
The formula would be as follows:
Risk premium = i Country with more risk - i Reference country
where i is the interest rate.
In the case of Europe, Germany is the reference country to calculate the risk premium of the other countries, since its economy is considered to be more solid, and its debt is considered to have less risk.
For example, if Germany paid 0.5% interest on its government debt, and Spain paid 2.2%, the difference between the two interest rates would be 1.7%. To express the risk premium as basis points, this figure is multiplied by 100, and so Spain's risk premium would be 170 points with respect to Germany.
The risk premium is one way of gauging the confidence of investors in an economy. When investor confidence in a country falls, the risk premium rises, and vice-versa - when there is greater confidence in a country's economy, its risk premium falls.