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Are 3 Year Risk Premia Too Cheap?

30 October 2014 by lberuti

One would expect the risk premium curve of a company to be closely related to its debt profile. In reality, as you can see on this grapple, as long as the 5 year risk premium is below 500, the 3 year risk premium dispersion is very low. The 3 year risk premium is roughly a linear function of the 5 year risk premium. One can argue that, for companies whose 5 year risk premium is trading below 500bps, the actual default risk is fairly remote, which would justify this one size fits all pattern. In such an environment, one would then expect the risk premia to increase in a linear fashion up to 5 year, and the 3 year risk premium should be worth 3/5 of the 5 year risk premium. But if you look closely at this grapple, you will see that it is only worth 1/2 of it. Once again that can be explained by saying that given the near zero interest rate environment, no one will default soon and that there is no point is paying premium for short dated protection. That is good news for investors who are less sanguine about the future. They have the opportunity to buy 3 year protection which has a very limited roll down (most of it takes place between the 5 year and 3 year points) and which will have the same dynamics as the 5 year if the market widens. Their only real downside is a more speculative liquidity.