Risk PremiumDefined along with Examples

Written By:
Lisa Borga

What is a Risk Premium?

The risk premium is the return that an investment is expected to generate above the risk-free rate of return.

The risk premium is the compensation that an investor will receive in return for the risk inherent to an investment over the return that they could receive from a risk-free investment, also known as the guaranteed rate of return.

This means that a lower-risk investment such as bonds issued by large established corporations will generally offer lower returns due to the higher chances of seeing those returns.

For investments in established companies with poor profitability or less established companies, the risk of not receiving returns increases, and as a result, these investments will typically offer higher interest rates.

How Risk Premium Works

The risk premium is the pay you receive for accepting the risk of not receiving returns.

When an investor faces a higher risk of not receiving returns and losing their investment, they expect to receive greater compensation.

This compensation is provided in the form of the risk premium, which is simply the amount an investor could receive in excess of the risk-free rate of return.

A truly risk-free investment does not exist, but the closest investment which is often used as the risk-free rate of return is U.S. government securities.

These are backed by the U.S Treasury, which is unlikely to default, meaning investors can be confident in earning their promised return with only a slight resale risk.

However, by accepting the risk of losing their money to a business failure and not earning their returns unless the business is successful, investors can earn a risk premium.

The risk premium can be thought of as a direct earnings reward.

This is because a high-risk investment is more profitable should it turn out successful.

Investments in safe markets that are likely to succeed will generally pay out low returns.

However, an investment in a new and risky project can offer significantly better returns.

This fact is used by many risky business ventures to attract potential investors, and this is the reason that some investors choose to focus on these high-risk ventures.

If these ventures succeed and do provide returns, then the reward will be much higher.

Premium Costs

For those seeking to borrow money, a risk premium can pose a high cost, particularly for those with highly uncertain futures.

For these borrowers, a high-risk premium will come with the cost of higher interest rates demanded by investors.

However, the higher this financial burden is, the less likely the borrower may be to succeed.

For this reason, investors would often be well advised to consider how high a risk premium they wish to demand.

The alternative may be no returns at all or simply pennies on the dollar in the case of high debt bankruptcies.

The Equity Risk Premium

The equity risk premium is the additional return an investor receives from investing in

the stock market rather than at a risk-free rate.

The additional return is the

compensation an investor receives for the somewhat higher risk they assume when investing in stocks.

This premium varies in amount based on the risk the investor takes in their portfolio as well as fluctuations in market risk.

Therefore, investments with a high amount of risk provide a greater premium.

A majority of economists believe that an equity risk premium does exist despite a lack of consensus on why this is as well as that in the long term, investors are rewarded by the market for the risk associated with investing in stocks.

There are a few ways to calculate the equity risk premium; however, the capital asset pricing model is one of the most common methods used.

CAPM(Cost of Equity)=Rf​+β(Rm-Rf​)

Rf​=Risk-free rate of return

β=Beta coefficient for the stock market

Rm​−Rf​=Equity risk premium

The equity risk premium is basically the cost of equity.

Rf indicates the risk-free rate of return, and Rm-Rf is the additional return of the market, which is multiplied by the beta coefficient of the stock market.

The equity risk premium was reasonably high during the years of 1926 through 2002 at 8.4% as compared to the rate of 4.6 that existed from 1871-1925 or the rate of 2.9% from 1802-1870.

Economists are unsure as to why the premium has been so much higher since 1926.

The ERP has been 5.5 for the years 2011 to 2021.

The average equity risk premium for the entire time period has been approximately 5.4.

Example of Risk Premium

In most cases, the risk premium for an investment is equivalent to the investment’s return minus the return that an investor could have earned on a risk-free investment.

For example, if an investment in opening a new store location offered an estimated return of 5% and investing the money in U.S. Treasury Bonds offered a 2% rate of return, the risk premium is equal to 3%.

This 3% is the amount that the investor could hope to earn by making a higher-risk investment.

Key Highlights

• The risk premium is the return an investment is forecasted to generate beyond that which could be earned from the risk-free rate of return.
• All investors expect compensation for the risk they undertake in making an investment. This return is the risk premium.
• The higher risk associated with purchasing stocks is reflected by the equity risk premium.