The Relationship between Risk Premium and Risk-Free Interest Rate: Evidence from Sovereign CDS Spreads

This chapter addresses the question of whether the risk premium and the risk-free interest rate on the capital market tend to develop in the same or opposite direction or are to be understood as independent of each other. While considerations regarding the direction of this relationship are not entirely new, they have gained particular relevance and sparked intense discussions, such as in the context of company valuations, due to the historically unprecedented low interest rates prevailing until the end of 2021. A positive relationship is theoretically derived from the convexity of the value function of financial instruments. The empirical analysis, covering the period from January 2008 to December 2020, employs an autoregressive distributed lag model. Sovereign CDS spreads of ten countries with very good to best ratings are used to operationalize forward-looking risk premiums. The risk-free interest rate is operationalized by bond yields of the countries themselves and by bond yields of other countries. Overall, the empirical results suggest a positive relationship between the two variables.