Risk Premium Definition
The risk premium is the minimum amount of money that a person is willing to accept as compensation for taking on a risky or volatile investment.
So, in investing, it is the minimum amount of money by which the expected return on a risky investment exceeds the known return on a non-risky asset.
A risk premium is a sort of hazard pay for your investments. Riskier investments – typically the more volatile ones – have to provide investors with the potential for higher gains than those that are risk-free, in order to convince the investors the risk is worthwhile.
Please note that the estimated return is not always the same as the returns that will eventually be realized. In some cases, such as zero coupon bonds, the expected return is well defined. In other cases, for example an equity stock, the expected return is implicit in how the market prices the asset.
Types of Risk Premium
There are a few categories of risk premiums.
Liquidity Risk Premium
This is the premium that investors request in exchange for being given a security that is illiquid – that is, it can’t be easily converted into cash at its market value.
Default Risk Premium
This is the amount that a borrower has to pay to a lender to compensate them for assuming the risk of the borrower defaulting on their debts. Typically, the U.S. government is exempt from this premium.
Country Risk Premium
the additional risk that an investor assumes by investing in international companies instead of the domestic market. There are a lot of other factors that come into play when dealing with international investments, including political instability, changing exchange rates and more.
Market Risk Premium
The difference between the expected return on a stock portfolio and the return on a risk-free option, like government treasury bonds. It’s calculated by looking at the slope of the security market line, which is a graph of the capital asset pricing model.
Equity Risk Premium
This is the excess return that an investor can hope to get from investing in the stock market over low-risk options like government treasury bonds. It can only be estimated, since no one can entirely predict exactly how well a stock will fare.
Calculating Risk Premium
There are three steps to calculating risk premium:
1. Estimate the Expected Returns on a Stock
2. Estimate the Expected Returns on a Risk-Free Bond
3. Subtract the Difference Between the Two
The number you have at the end is the risk premium. The other varieties of risk premium are dependent on their definitions and the specific situation.
Risk premiums are a good way to determine whether a risky or volatile stock is worth your investment. Always be sure to find out what yours is and ensure that you are making wise financial decisions!