When people consider which investment to make, it’s usually a question of whether the expected return is high enough to compensate for the level of risk they’re willing to take. This additional return is referred to as a risk premium in financial terminology.
What Is a Risk Premium?
A risk premium is the projected return on an asset that is higher than the risk-free rate of return. The risk premium on an asset is a sort of remuneration for investors. It’s a way of compensating investors for taking on more risk in a given investment than they would in a risk-free asset.
High-quality bonds issued by well-established firms with considerable earnings, for example, usually have a low risk of default. As a result, these bonds pay a lower interest rate than bonds issued by less-established enterprises with a larger risk of default and uncertain profitability. Investors are compensated for their increased risk tolerance by requiring these less-established enterprises to pay higher interest rates.
A risk premium is the projected return on an asset that is higher than the risk-free rate of return.
When making an investment, investors expect to be compensated for the risk they accept. This is expressed as a risk premium.
The equity risk premium is the return on investment that investors expect to receive in exchange for taking on the increased risk of investing in equities.
How a Risk Premium Works
Consider risk premium to be a type of hazard compensation for your assets. An employee who is assigned to dangerous labor expects to be compensated for the risks they assume. It’s the same with high-risk investments. To compensate an investor for the danger of losing some or all of their money, a risky venture must offer the possibility of higher returns.
This remuneration is in the form of a risk premium, which is the additional return above and beyond what may be earned risk-free from investments like US government securities. The premium compensates investors for the risk of losing money in a failing company, and it is not earned unless the company succeeds.
Because riskier ventures are naturally more profitable if they succeed, a risk premium can be viewed as a true earnings reward. Investments in well-developed markets, which have predictable consequences, are unlikely to transform the world. Paradigm-shifting innovations, on the other hand, are more likely to originate from unique and hazardous ventures. These are the kinds of investments that have the potential to provide higher returns, which a business owner may then employ to reward investors. This is one of the underlying motivations for some investors to seek out riskier assets in the hopes of reaping larger rewards.
For borrowers, especially those with shaky prospects, a risk premium can be pricey. These borrowers must pay a larger risk premium to investors, which is reflected in higher interest rates. However, by taking on more financial responsibility, they may jeopardize their prospects of success, raising the risk of default.
With this in mind, it’s in investors’ best interests to think about how much risk premium they’re willing to pay. Otherwise, in the case of a default, they may find themselves fighting over debt collection. Despite the original promises of a high-risk premium, many debt-laden bankruptcies only return a few pennies on the dollar to investors.
The Equity Risk Premium
The excess return provided by investing in the stock market over a risk-free rate is known as the equity risk premium (ERP). This extra profit compensates investors for taking on the additional risk of stock purchases. The premium size varies depending on the level of risk in a portfolio and also changes over time as market risk swings. High-risk investments are usually compensated by a higher premium. Most economists agree that the concept of an equity risk premium is correct: over time, markets reward investors for taking on the higher risk of stock investing. 1
The equity risk premium can be calculated in a variety of methods, but the capital asset pricing model (CAPM) is commonly used:
The equity risk premium is effectively the cost of equity. Rf is the risk-free rate of return, and Rm-Rf is the market’s excess return multiplied by the beta coefficient of the stock market.
The stock risk premium was relatively high from 1926 to 2002, at 8.4%, compared to 4.6 percent in the 1871-1925 era before it and 2.9 percent in the previous 1802-1870 period. Economists are baffled as to why the premium has risen so dramatically since 1926. The ERP increased by 5.5 percent from 2011 to 2021. The stock risk premium has averaged roughly 5.4 percent in recent years.
Risk premiums are the additional returns that investors expect from an investment based on its amount of risk.