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WHAT IS THE RISK PREMIUM?

This concept did not seem to matter many years ago; it wasn’t discussed much and was unknown to many. But since the crisis began in 2008, the risk premium has come alive, so much so that today it has become one of the most interesting economic issues widely spread by the media.
The Risk Premium
The risk premium or country risk is the surcharge that a country pays,for getting its funds from markets, in comparison with other countries. If the country risk is high its interest rate will be higher than if the country risk is low. In other words it is the expected return for the investor when they buy the country’s debt. The risk premium is a measure of reliability for investors indicating the stability of an economy, the expected return is low when the risk islow and is bigger when the risk is bigger.
In the European Union, the risk premium of a country is calculated in comparison with the risk premium of Germany, because it is supposed that the German economy is safer and has less risk than the rest of the economies in the European Union. The safety and solvency in the country’s economy is measured by credit rating agencies and currently the mostimportant agencies are: Standard & Poor's, Fitch and Moody's.
The main buyers of the securities are called institutional investors: banks and large investment funds.
What is the public debt?
Public debt is money owed by thecentral government. When a State needs money because it wants to finance investments in long or medium terms, or because it needs money for meeting impending payments, thenit normally issues government bonds. Public debt can be categorized as internal debt when it is owed to national markets or as external debt when it is owed to foreign markets.
Later the State should pay to these lenders with a fixed return, the bond’s return depends on two factors: demand and term of maturity. When there is low demand the interest rate is greater than when the demand is high,the State will pay more because the risk is high. For the second factor, theStatewill usually pay more when the deadline is long, the return will be high to investors because they cannot recover their money for a long period of time.
Consequence of a high-risk premium
When the risk premium of a country is high, banks in the country are affected, they will access more expensive credits(withhigher interest rates) and with worse conditions in the exchange market. This circumstance affects businesses and individuals who apply for loans: banks grantless creditand with higher interest rates, companies have financing problems and are forced to take measures such as the dismissal or close down of a part of the firm. A rising unemployment and higher interest rates reduce consumption. A decreasein consumption means a reduction in tax revenues, less business and job creation leading to an increase in unemployment benefits. The country's economic growth can be greatly impaired.
The stock of that country is also affected as institutional investors do not trust the economy and investors do not plan investments in risky economies.
The higher the risk premium, the more problems the statewill have to find funds and it will have to pay more interest rates to investors.
The risk premium in the European Union
Since the beginning of the economic crisis in 2008, every countries from the euro area have experiencedfluctuations intheir risk premiumdueto debt increaseandthe risk thatthey can’t cope withit.
In thesetimes of uncertaintydue to the crisis, investors choose tobuy shares thatprovidesecurity evenif the profitabilityis lower by fear thatcountries withproblemscannotpay back what they owe. So investors prefer to invest in the German bond, which causes a decrease in the profitability (more demand)while interests for other countries in the euro area are increasing.
Countries such as Greece, Ireland and Portugal have already experienced financial rescue by the Union...