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Activity Handout

Corporate Risk Premium

Author

Diego Mendez-Carbajo, Department of Economics, Illinois Wesleyan University

dmendez@iwu.edu

Step-By-Step Activity Description

The user of the FRED database will take the following steps in order to quantify the concept of risk premium.

(Step 1)

The user will first generate a graph of Moody’s Seasoned Baa Corporate Bond Yield (BAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody’s)

(Step 2)

The user will then “Add a Data Series > Add New Series”, graphing Moody’s Seasoned Aaa Corporate Bond Yield (AAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody’s)

(Step 3)

The user will then “Edit Data Series 2” (Moody’s Seasoned Aaa Corporate Bond Yield (AAA)) by deleting it [click on trash can icon to the right of the series’ name].

Next, the user will “Add a Data Series > Modify Existing Series > Data Series 1”, graphing Moody’s Seasoned Aaa Corporate Bond Yield (AAA) (Category: Money, Banking & Finance > Interest Rates > Corporate Bonds > Moody’s)

These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting “Create Your Own Data Transformation > Formula > a – b > Apply”

The graph now plots the difference between Baa and Aaa Moody’s Seasoned Corporate Bond Yields, a computation of the risk premium between two different classes of financial assets.

Suggested Discussion Questions

• How does the corporate risk premium change in value during economic expansions and contractions? Why?

• What would you say was remarkable about the evolution of the corporate risk premium before, during, and after the 2008-2009 recession?

Further Sophistications

• Plot the difference between the Aaa Corporate Bond (AAA) and a “risk-free asset” (e.g. the 3-Month Treasury Bill: Secondary Market Rate (TB3MS)

• Plot the corporate risk premium (BAA-AAA) against the CBOE Volatility Index VIX (VIXCLS). How effective is the VIX index in capturing corporate risk?

• Plot the CBOE NASDAQ 100 Volatility Index (VXNCLS) against the CBOE Volatility Index VIX (VIXCLS). What set of assets is riskier? How would you expect that risk difference to behave?

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