Why do risk premiums change over time?

Risk premiums change because the supply and demand for risk-bearing capacity changes. When liquidity is abundant and investor confidence is high, investors are willing to accept lower compensation for risk — compressing risk premiums. When liquidity contracts or uncertainty rises, investors demand higher compensation — expanding risk premiums. Risk premiums are also regime-conditional: the equity risk premium is structurally lower in Goldilocks (high growth, low uncertainty) and higher in Stagflation (low growth, high uncertainty).

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What Is a Risk Premium and Why Does It Change Over Time?

Q: What is a risk premium?

A risk premium is the excess return that investors demand above the risk-free rate to compensate for bearing a specific type of risk. The equity risk premium (ERP) is the excess return of equities over risk-free bonds. The term premium is the excess return of long-duration bonds over short-duration bonds. The credit risk premium is the excess return of corporate bonds over government bonds. Risk premiums are not fixed — they expand and compress with the macro regime, liquidity conditions, and investor risk appetite.

A risk premium is the excess return investors demand above the risk-free rate to compensate for bearing a specific risk. Key types: equity risk premium (equities over bonds), term premium (long over short duration), credit risk premium (corporate over government bonds), and liquidity risk premium (illiquid over liquid assets). Risk premiums are not fixed — they compress in Goldilocks (abundant liquidity, high confidence) and expand in Stagflation (scarce liquidity, high uncertainty).

AhaSignals Research · Not investment advice

The Four Major Risk Premiums

Risk Premium	Definition	Regime Sensitivity
Equity Risk Premium	Excess return of equities over risk-free rate	High — compresses in Goldilocks, expands in Stagflation
Term Premium	Excess return of long over short duration bonds	High — compresses in Deflation, expands in Stagflation
Credit Risk Premium	Excess return of corporate over government bonds	High — compresses in Goldilocks, expands in Contraction
Liquidity Risk Premium	Excess return of illiquid over liquid assets	Very high — spikes during liquidity contractions

Confidence level: Well-supported. Not investment advice.

Known Limitations

Risk premiums are not directly observable — they must be estimated from market prices and models
Risk premium estimates have wide confidence intervals, especially over short horizons
Not investment advice.