Long-term investors are attuned to the thought that risk is rewarded. By making an investment with more potential variation in returns, investors demand a risk premium – the expected return in excess of a comparatively risk-less investment. This is particularly espoused in the long-term investments of pension funds, yet is a reductive view of financial markets. We investigate the realized risk premiums in a global, multi-asset portfolio of a typical pension fund between 1999–2015, and relate the variation of the realized risk premiums to macroeconomic fluctuations. Owing to the coincident relation between the realized risk premiums and the economic cycle, under the prevailing economic condition, the Sharpe ratios of portfolios constructed ex post to capitalize on risk premiums are appallingly low (between −1 and 0.2). Therefore, despite the heartening corroboration of risk premiums’ existence, investors are susceptible to their time variation.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Tax calculation will be finalised during checkout.
Other justifications for pension funds to invest in equities include the asset class’ ability to hedge inflation and/or wage risk. This is relevant for indexed pension benefits (Sundaresan and Zapatero, 1997).
' denotes the complex conjugate transpose of the matrix.
We adopt an approximate factor model by assuming that F t and e t are uncorrelated, though the asset returns’ idiosyncratic components are allowed to have a limited degree of dynamic cross-correlation. Formally, this means that the matrix comprised of cov(e i , e j ) is not necessarily diagonal, but the largest eigenvalue of the idiosyncratic component’s covariance matrix is bounded. Chamberlain and Rothschild (1983) present the approximate factor structure in detail, outline the conditions that justify its application, and suggest Principal Component Analysis to estimate the factors.
For an exposition of PCA applied to financial data, confer Alexander (2001).
Boon and Ielpo (2014) consider global equity indices, government bonds, currencies, futures, and commodities.
The risk-free rate is the US government three-month Treasury bill.
Assuming that the eigenvalues are ordered by magnitude, θ1<θ2<…<θ N . For i=1…N, is the amount of variation explained by the ith PC.
For example, volatile investment values are undesirable for a corporate-sponsored defined-benefit fund because the sponsor has to recognize unfunded liabilities on its balance sheet under major accounting regulations. This is a provision under the Financial Accounting Standard (FAS) 158 currently followed by incorporated firms in the United States, and the International Accounting Standards (IAS) 19 adopted by almost all of the rest of the world.
In 2015, for instance, 4 out of 10 of the main constituents of the MSCI Emerging Europe Index are Russian energy companies that measures about 20 per cent of the index’s weight) (MSCI Emerging Markets Europe Investable Market Index (IMI) Fact Sheet, 2015).
Energy weighs close to 35 per cent of the Bloomberg Commodity Index (Bloomberg Commodity Index Fact Sheet. 31 August 2015).
The eigenvector scaling to restrict the standard deviation of the factor portfolio returns to be less than 10 per cent applies to the entire sample period. This does not rule out the possibility that within the sample period, the standard deviation exceeds 10 per cent.
Majority of the countries covered by the indices that constitute the portfolio are members of the Organization for Economic OECD.
In contrast, real consumption growth is known to be smooth. In the United States, for instance, annualized standard deviation for seasonally adjusted real consumption growth in the 1980s–1990s is 1.1 per cent (Campbell, 2003).
Alessi, L., Barigozzi, M. and Capasso, M. (2010) Improved penalization for determining the number of factors in approximate factor models. Statistics & Probability Letters 80 (23): 1806–1813.
Alexander, C. (2001) Market Models: A Guide to Financial Data Analysis. Chichester, UK: John Wiley & Sons.
Asprem, M. (1989) Stock prices, asset portfolios and macroeconomic variables in ten european countries. Journal of Banking & Finance 13 (4): 589–612.
Bai, J. and Ng, S. (2002) Determining the number of factors in approximate factor models. Econometrica 70 (1): 191–221.
Balvers, R.J., Cosimano, T.F. and McDonald, B. (1990) Predicting stock returns in an efficient market. The Journal of Finance 45 (4): 1109–1128.
Boon, L.-N. and Ielpo, F. (2014) Determining the maximum number of uncorrelated strategies in a global portfolio. The Journal of Alternative Investments 16 (4): 8–27.
Breeden, D.T., Litzenberger, R.H. and Jia, T. (2015) Consumption-based asset pricing, Part 1: Classic Theory and Tests, Measurement Issues, and Limited Participation. Annual Review of Financial Economics 7 (1): 35–83.
Campbell, J.Y. (2003) Consumption-based Asset Pricing. In: G. Constantinides, M. Harris and R. Stulz (eds.) Handbook of the Economics of Finance. Vol. I-B. North Holland, Amsterdam: Elsevier Science B.V., pp. 803–887.
Campbell, J.Y. and Cochrane, J.H. (2000) Explaining the poor performance of consumption-based asset pricing models. The Journal of Finance 55 (6): 2863–2878.
Chamberlain, G. and Rothschild, M. (1983) Arbitrage, factor structure, and mean-variance analysis on large asset markets. Econometrica 51 (5): 1281–1304.
Chen, N.-F. (1991) Financial investment opportunities and the macroeconomy. The Journal of Finance 46 (2): 529–554.
Chen, N.-F., Roll, R. and Ross, S.A. (1986) Economic forces and the stock market. Journal of Business 59 (3): 383–403.
Cheung, Y.-W. and Ng, L.K. (1998) International evidence on the stock market and aggregate economic activity. Journal of Empirical Finance 5 (3): 281–296.
Cochrane, J.H. (1991) Production-based asset pricing and the link between stock returns and economic fluctuations. The Journal of Finance 46 (1): 209–237.
Connor, G. and Korajczyk, R.A. (1993) A test for the number of factors in an approximate factor model. Journal of Finance 48 (4): 1263–1291.
Cooper, I. and Priestley, R. (2009) Time-varying risk premiums and the output gap. Review of Financial Studies 22 (7): 2801–2833.
Errunza, V. and Hogan, K. (1998) Macroeconomic determinants of european stock market volatility. European Financial Management 4 (3): 361–377.
Fama, E.F. (1981) Stock returns, real activity, inflation, and money. The American Economic Review 71 (4): 545–565.
Fama, E.F. (1990) Stock returns, expected returns, and real activity. The Journal of Finance 45 (4): 1089–1108.
Fama, E.F. and French, K.R. (1993) Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33 (1): 3–56.
Hahn, J. and Lee, H. (2006) Yield spreads as alternative risk factors for size and book-to-market. Journal of Financial and Quantitative Analysis 41 (02): 245–269.
Hardouvelis, G.A., Malliaropulos, D. and Priestley, R. (2006) Emu and european stock market integration*. The Journal of Business 79 (1): 365–392.
Hodges, C.W., Taylor, W.R. and Yoder, J.A. (1997) Stocks, bonds, the sharpe ratio, and the investment horizon. Financial Analysts Journal 53 (6): 74–80.
Hong, H., Torous, W. and Valkanov, R. (2007) Do industries lead stock markets? Journal of Financial Economics 83 (2): 367–396.
Lamont, O.A. (2001) Economic tracking portfolios. Journal of Econometrics 105 (1): 161–184.
Lin, M.-C. and Chou, P.-H. (2003) The pitfall of using sharpe ratio. Finance Letters 1 (3): 84–90.
Longstaff, F.A., Pan, J., Pedersen, L.H. and Singleton, K.J. (2011) How sovereign is sovereign credit risk? American Economic Journal: Macroeconomics 3 (2): 75–103.
Lucas, R.E. (1978) Asset prices in an exchange economy. Econometrica: Journal of the Econometric Society 46 (6): 1429–1445.
Ludvigson, S.C. and Ng, S. (2009) Macro factors in bond risk premia. Review of Financial Studies 22 (12): 5027–5067.
Merton, R.C. (1980) On estimating the expected return on the market: An exploratory investigation. Journal of Financial Economics 8 (4): 323–361.
Moskowitz, T.J., Ooi, Y.H. and Pedersen, L.H. (2012) Time series momentum. Journal of Financial Economics 104 (2): 228–250.
Novosyolov, A. and Satchkov, D. (2008) Global term structure modelling using principal component analysis. Journal of Asset Management 9 (1): 49–60.
Onatski, A. (2009) Testing hypotheses about the number of factors in large factor models. Econometrica 77 (5): 1447–1479.
Shanken, J. and Weinstein, M.I. (1990) Macroeconomic Variables and Asset Pricing: Further Results, William E. Simon Graduate School of Business Administration, University of Rochester, Bradley Policy Research Center, Managerial Economics Research Studies. Working Paper Series, MR 91-05.
Sundaresan, S. and Zapatero, F. (1997) Valuation, optimal asset allocation and retirement incentives of pension plans. Review of Financial Studies 10 (3): 631–660.
Towers Watson (2015) Global pension assets study, https://www.towerswatson.com/en/Insights/IC-Types/Survey-Research-Results/2015/02/Global-Pensions-Asset-Study-2015, accessed 27 April 2016.
Verdelhan, A. (2010) A habit-based explanation of the exchange rate risk premium. The Journal of Finance 65 (1): 123–146.
Wachter, J.A. (2006) A consumption-based model of the term structure of interest rates. Journal of Financial Economics 79 (2): 365–399.
The authors would like to thank Douglas Breeden, Marielle de Jong and an anonymous reviewer of the journal for their suggestions. The views and opinions expressed herein do not necessarily state or reflect those of Amundi or Unigestion.
About this article
Cite this article
Boon, LN., Ielpo, F. An anatomy of global risk premiums. J Asset Manag 17, 229–243 (2016). https://doi.org/10.1057/jam.2016.16
- sharpe ratio
- risk premium
- long-term investing