Risk premium – equity, credit, volatility: which premium should be preferred?

Inflation and rising rates have had a strong impact on markets in terms of efficiency since the beginning of this year in 2022. Within the distribution, it is important to consider the context of risk premiums.

Alexander Rio, Development Manager, Overlay & Customized Portfolio Solutions

Stock market risk premium

We will now focus on the US market, which has been hit hardest by the Fed’s rate hike and monetary policy. Importantly, when we analyze the S & P500 and its risk premium based on earnings per share expectations, we notice that its negative results this year and its price change are almost entirely due to higher rates.

06/24/2022  Actions on the risk premium

Thus, as we can see in the chart below, despite the S & P500 falling by more than 20% in 2022, the gap between the stock risk premium and the rates remains narrowed at 2.5%. This level remains at its lowest level in 10 years and has not yet undergone a revaluation similar to that we experienced during stressful periods, such as 2020, 2015 or even 2018 during the last EDF decline.

06/24/2022  Risk against the rate

Risk premium based on strong growth expectations

The stock market risk premium is by definition based on expected results relative to the market price. After a preliminary study, it is worth pausing for a moment on these earnings projections to assess whether this level of compressed risk premium seems logical or not.

24.06.2022 Risk premium

Therefore, analysts expect the results to grow by 18% in 2022 and then by 9% in 2023. It is worth forgetting about the Covid period and compare these forecasts with 2019 to find the expected growth year on year. So, in summary, the current risk premium assumes a profit growth of 12/13% over the next few years. Thus, the equity risk premium would be even more expensive if 0% 1% 2% 3% 4% 5% 6% 7% 8% 01/04 10/06 07/09 04/12 12/14 09/17 06/20 03/23 12/25 The spread risk premium against level 3 of this growth was not achieved; for example, the result of 2023, which will remain neutral compared to 2021, will give a premium for equity risk against rates not at 2.5% but at 1.3%.

Comparison of the equity risk premium with the credit risk premium

After analyzing the equity risk premium, which may now seem excessive to us, it should be compared with other risk premiums to place it in a more general context. So, when we look at the option-adjusted spread of investment grade and high-yield indices in the US market, we get the following chart:

06/24/2022  Distribution options

As we see here, price changes occur in credit markets, both investment grade and high yield. Basically, because stocks are a real asset with attractive inflation-indexed results, this difference in response can be justified. However, it will be necessary to avoid the risk of recession or global decline in leverage associated with increased risk (volatility of risky assets). Carrying out a more accurate analysis, in particular on the basis of the investment rating, we see that the premium for equity risk can be recalculated by 1%. In this case, faced with the S & P500 index at 3750 points, a change in the price of 1% of the risk premium will affect the index by falling by -15%.

2022.06.24.common IG

Explore additional bonuses and related profits

An easy way to get a fixed income through the stock market and thus get a loan-like product is to use the options market. Based on this strategy, many structured products have been created that protect against falling markets. Here we are simply considering a 1-year level of put option that needs to be sold on the S & P500 to get a return similar to an investment grade investment. At the moment, it is advisable to sell the level of -37% to get a return of 1.7%, similar to the investment class. Historically, this level seems far from what we might have. However, this must be taken into account in the context, following what we have described earlier. Indeed, if the equity risk premium were closer to the credit risk premium, the stock market would have to be 15% lower. Thus, the sold option will no longer be at -37%, but -22%, which historically seems very close. This revaluation, if it occurred, would only be related to the risk premium. A decrease in the expected results and their strong growth would also lead to a sharp revaluation of the index and would bring the level of this sold object closer to construction.

2022.06.24.strike struck


Thus, this analysis underscores the fact that the stock market does not currently seem to expect a decline in earnings growth or even a revaluation of the risk premium associated with the simple exchange of flows between different asset classes. On the other hand, hedging flows have affected option premiums, which offset this high stock market value and may now seem more attractive than credit risk premiums. However, we must not forget about the risks associated with the possible revaluation of shares in these derivatives.

Therefore, today it seems more interesting to help increase the fixed return on credit assets (investment level or high return), which have already experienced a negative effect of the risk premium, and to limit the risk of revaluation of stock markets by supporting hedging. faster than we imagine, especially when we see the high realized volatility of stock markets today.

WARNING : this commercial document is not investment advice or advice to buy or sell financial products. Investors who plan to subscribe for UCI shares or stocks are advised not to base their decisions solely on the elements contained in this document, but to carefully read the latest version of the prospectus and, in particular, the risk profile. The UCI and KIID brochures are available on request from the management company or on the website: www.ellipsis-am.com. The distribution and offering of UCI shares or units may be restricted or prohibited by law in certain jurisdictions. The UCI may not be signed or retained by an Unauthorized Person or an Inappropriate Intermediary (see the “Relevant Subscribers” section of the prospectus). Before any subscription, you should check in which countries the UCIs mentioned in this document are registered.

Disclaimer for overlay decisions: its purpose is to reduce the risks of a particular portfolio without eliminating them completely and is not intended to offer any guarantees or protection for the portfolio, which therefore remains at risk of losing capital. This solution is also more specifically exposed to the model risk associated with the implementation of the main goal of risk reduction, which is based on the system principle. There is a risk that this model is not effective. Finally, in addition to the specific risks associated with the existing portfolio, this solution introduces risks associated with the use of forward financial instruments, as well as operational risk. Due to the existence of hedging, the potential return may be lower due to the impact of hedging costs and the fact that the portfolio could only partially participate in the recovery in the event of a market rebound.

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