Risk premium

The risk premium, also known as country risk, is the difference between the interest that is paid for the debt of two different countries. This debt, or public debt, can be defined as the money that a country asks to borrow to finance its needs and, as with any loan, it comes with certain interest charges based on the confidence generated by each country's economy.

The value of the risk premium is established by comparing the interest rate applicable to the public debt of a country that has high-risk assets with those of a country which is considered to have risk-free assets and which is always taken as a benchmark over the same period of time. This differential is measured in basis points (a basis point is equivalent to 0.01%) and, in other words, it determines the return that investors demand from one country compared to the return they demand from another one. The more security that exists for lending money, the less interest is demanded.

A good way to show how this concept works in practice is by using an example. Let's imagine that ‘A’ is the country that is used as a benchmark for comparing against other countries, as it is the country that enjoys a lower interest rate on its public debt, at the rate of 1%. Meanwhile, the interest rate of ‘B’, the other country whose risk premium we want to calculate, is 3%. The risk premium is obtained by finding the difference between the two percentages and multiplying it by one hundred. Therefore: 3% - 1% = 2%, or 200 basis points, is the risk premium of ‘B’.

Theoretical and subjective concept

It is important to approach the concept of risk premium from its two different perspectives. On the one hand, it is a theoretical and arithmetic concept, as its value is obtained by finding the difference between two simple numeric variables. However, it would be impossible to avoid its subjective component, which always plays a decisive role in the financial markets and is directly related to the concept of confidence. The interest rate of a country's public debt is based on facts, but also on subjective assessments as a result of the future estimates and predictions of the markets.

In the Eurozone, Germany is taken as the benchmark to calculate the risk premium as it is the country with the safest assets. Therefore, the figure for all other European Union countries will be a comparison with the public debt interest rate of this country, although the country that is used as a benchmark can change over time depending on the circumstances.

Therefore, the risk premium is not simply a number, but also an economic indicator that affects the financial progression of each country. On the understanding that the higher the risk premium, the higher the cost of public debt, this factor will also dictate the cost of obtaining financing. In the end, it serves as an essential tool for measuring investor confidence in a particular economy and, at the same time, it is a factor that can either boost or hold back a country's economic growth depending on its value and how it changes over time.