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

The following paper 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. This fundamental consideration is not new, but has gained additional importance with the historically unprecedented interest rate level of the recent past. The paper investigates this question first theoretically and then empirically using an autoregressive distributed lag model. CDS spreads on various sovereigns with very good to best ratings are used to operationalize a forward-looking risk premium and thus the market price of risk. The risk-free interest rate is operationalized by own bond yields, but also those of other sovereigns. Overall, our results show a positive correlation and thus a tendency for the two variables to run parallel