A major component of Israel's risk premium is disappearing before our eyes, explains Finessa Capital CEO Gat Megiddo.
Two words dictate the tempo in Israel’s economy and capital market: risk premium. Ten days ago, the State of Israel embarked on an intensive military campaign against Iran, and in response the local stock market recorded one of its best ever weeks, with sharp rises, and the shekel strengthened to around NIS 3.5/$. Not an obvious result when Israel is fighting its largest and strongest enemy.
Once more it turns out that the stock market often behaves unexpectedly. Not every war triggers a fall. The risk premium offers the best explanation of what has happened on the Israeli stock market in the past two years, and particularly last week.
What is a risk premium?
A risk premium is an extra return that investors demand as compensation for the risk involved in an investment, in comparison with a risk-free investment. It’s an alternative expression to the cost of risk. Investors ask themselves what potential return to demand before agreeing to take on the risk of the investment. What is the cost of the risk that the investment will not yield the expected return, or may even lose money?
For example, if a ten-year Israel government bond yields 4% annual interest, and the stock of some commercial company is traded at a price that embodies a potential annual return of 9%, then the implication is that the risk premium on that stock is 5%. In other words, investors require an extra 5% return before they will switch from an investment considered safe to investment in that company’s stock.