XLF - Tap Dancing Over Lava
2024-07-12 18:32:24 ET
Summary
- Expected risk premia (ERP) is the compensation for risk in asset valuations, inversely related to risk tolerance.
- A primer on macroeconomic processes, monetary policy, and banking system functioning is provided.
- Emerging market economies face potential negative macroeconomic events due to original sin of borrowing in foreign currency.
- Effects on global asset classes are discussed.
Introduction
Objects appear smaller from a high altitude, and within this classification of objects, I would also include probabilities. The expected required compensation for the risk of a sharp drop in altitude or more aptly for this piece risk asset valuations is known as expected risk premia (ERP). ERP can be thought of as the inverse of risk tolerance. That is when risk tolerance is low, investors will demand a higher return on risk-on assets such as stocks and vice versa. Such that, when investors' risk tolerance is high, there will be less demanded premium over the return on a risk-free asset. ERP can be calculated by subtracting the return on a risk-free asset such as a US government bond from the expected return on a risky asset such as a stock.
The further perceived risk diverges from underlying economic fundamentals, the risk appears less and less significant and probable, until it is just a small speck in the distance....
Tap Dancing Over Lava