The term “risk premium” refers to the difference between the higher interest rates that riskier investments must pay to attract investors and the interest rate of the risk-free investment. Thus, it is the return in excess of the risk-free rate of return than an investment is expected to yield. It is a compensation for investors to bear more risk and hold the risky asset rather than the risk-free asset. The risk premium is positive, since people are generally risk averse, i.e. they dislike risk. The risk premium explains why, for example, stocks have higher expected returns than a bank account or Treasury bonds.
Risk Premium and Gold
When risk premium increases, the situation is bullish for gold, since there is more perceived risk in the economy and investors are demanding higher compensation for bearing additional risk, and shifting some funds into safe-haven investments, such as gold. Conversely, when risk premia decrease, investors are less afraid, consequently reducing their demand for safe-haven assets (such as gold). The chart below shows the relationship between the price of gold and the credit spread between bonds that are below investment grade (those rated BB or below) and Treasuries, which indicates the risk premium in the market. Actually, credit spreads are one of the best indicators of economic confidence, with widening credit spreads generally signifying declining confidence and narrowing credit spreads generally signifying rising confidence.
Chart 1: The BofA Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread (green line, left axis, in percent) and the price of gold (yellow line, right axis, P.M. London Fix).
As one can see, a rise in credit spreads between 2007 and 2009 proved to be bullish for gold, while the narrowing of credit spreads between 2011 and 2014 was accompanied by a decline in the price of gold. However, the correlation is not perfect (credit spreads tightened between 2003 and 2007, while the shiny metal enjoyed a bull market). It means that credit spreads alone, though a theoretically important factor in the gold market, cannot fully explain the dynamics of the price of gold. Investors should also pay attention to other factors, such as real interest rates and the U.S. dollar exchange rate.
To sum up, when risk premia increase, the price of gold declines, and when the economic confidence declines, gold shines, as an ultimate safe-haven asset.
We encourage you to learn more about gold – not only how it is affected by the risk premium, but also how to successfully use the shiny metal as an investment and how to profitably trade it. Great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.