Factors Driving Risk Premia

         This paper assesses the extent to which the fall in risk premia of a number of financial assets, which occurred throughout 2003, was due to improvements in factors specific to individual markets at that time or to general economic fundamentals coupled with OECD-wide abundant liquidity. Regarding the latter two factors, principal component analysis was used here to identify a common trend in risk premia in equity, corporate bond and emerging markets since early 1998. The analysis finds that both economic fundamentals and liquidity have played a statistically significant role in driving the common factor. It also finds that liquidity (measured as the GDP weighted average of M3 of the three major economies less its trend) performs better than similarly weighted short-term interest rates. By spring 2004, the common factor in different risk premia had fallen below what could be explained by economic fundamentals and liquidity ...      