Twin Peaks: The Effect of Terrorism and Financial Shocks on Short-Run Fluctuations in the Risk Premium for 10-year Corporate Bonds

From the 1950s to the present, the risk premium for 10-year corporate bonds vis-a-vis government bonds has gradually increased. While this long-run upward trend in the corporate bond risk premium is relatively stable, short run movements in the risk premium exhibit significant variation. Certain periods are particularly volatile, with fluctuations in the risk premium reaching a magnitude of 100 basis points within the span of one year. In the majority of these cases, sharp changes in the risk premium occur subsequent to shocks related to political uncertainty and/or financial market uncertainty. This study examines the influence of financial and political shocks on the short run variability in the risk premium for 10-year corporate bonds from 1998 to the present. The analysis is conducted by controlling for prior month data, monetary policy, and shocks occurring between April 1998 and April 2005 in a multivariate model. The results indicate that financial and political shocks are significant in explaining short-run variations in the corporate bond risk premium. This article is available in Undergraduate Economic Review: http://digitalcommons.iwu.edu/uer/vol2/iss1/8 Twin Peaks: The Effect of Terrorism and Financial Shocks on Short-Run Fluctuations in the Risk Premium for 10-year Corporate Bonds Justin T. Patterson Undergraduate Student Ball State University 12/5/2005 Abstract: From the 1950s to the present, the risk premium for 10-year corporate bonds vis-a-vis government bonds has gradually increased. While this long-run upward trend in the corporate bond risk premium is relatively stable, short run movements in the risk premium exhibit significant variation. Certain periods are particularly volatile, with fluctuations in the risk premium reaching a magnitude of 100 basis points within the span of one year. In the majority of these cases, sharp changes in the risk premium occur subsequent to shocks related to political uncertainty and/or financial market uncertainty. This study examines the influence of financial and political shocks on the short run variability in the risk premium for 10-year corporate bonds from 1998 to the present. The analysis is conducted by controlling for prior month data, monetary policy, and shocks occurring between April 1998 and April 2005 in a multivariate model. The results indicate that financial and political shocks are significant in explaining short-run variations in the corporate bond risk premium. From the 1950s to the present, the risk premium for 10-year corporate bonds vis-a-vis government bonds has gradually increased. While this long-run upward trend in the corporate bond risk premium is relatively stable, short run movements in the risk premium exhibit significant variation. Certain periods are particularly volatile, with fluctuations in the risk premium reaching a magnitude of 100 basis points within the span of one year. In the majority of these cases, sharp changes in the risk premium occur subsequent to shocks related to political uncertainty and/or financial market uncertainty. This study examines the influence of financial and political shocks on the short run variability in the risk premium for 10-year corporate bonds from 1998 to the present. The analysis is conducted by controlling for prior month data, monetary policy, and shocks occurring between April 1998 and April 2005 in a multivariate model. The results indicate that financial and political shocks are significant in explaining short-run variations in the corporate bond risk premium. ∗ Comments by Cliff Stone and Paula Malone as well as by discussants at the Midwest Economics Association undergraduate session are gratefully acknowledged. 1 1 Patterson: Twin Peaks: The Effect of Terrorism and Financial Shocks on Short Published by Digital Commons @ IWU, 2006