26 May What is Risk Premium?
Risk premium is the excess return that an investor can expect to earn over the risk-free rate. An investor would expect to earn more if the asset carries a higher level of risk. The risk premium can be seen as a form of compensation for deploying funds in a high-risk asset. The riskier the asset, the greater the risk premium.
To understand what risk premium means, it is important to grasp the concept of a risk-free return. Consider the level of risk associated with an investment in a U.S. government Treasury bond. This is considered to be a risk-free asset. If you invest in a U.S. Treasury bond, it is almost certain that you will get your money back.
So, if a Treasury bond yields a return of 3% per year, it can be considered to be the risk-free rate. Now, consider some other asset or financial security, say, a corporate bond issued by a company with a poor credit rating. If this bond offers a rate of return of 7% per year, the excess return is the risk premium.
Risk premium = rate of return – risk-free rate
Risk premium = 7% – 3%
Risk premium = 4%
An investor would be willing to buy a bond issued by this company only if an adequate level of compensation in the form of a risk premium is offered. Instead of a rate of return of 3%, the bond offers a rate of 7%. That’s because it carries a higher level of risk.
Example of risk premium
The stock of HR Inc., a company that mines gold, is expected to provide an annual return of 8%. The stock is expected to increase in value because gold prices are expected to rise. An investor would be willing to buy HR’s stock only if it offered the prospect of a return of 8% in the next 12 months.
The risk-free rate is 3%. The expected rate of return on the stock exceeds the risk-free rate by 5%.
Risk premium (5%) = Expected rate of return on HR stock (8%) – risk-free rate (3%)
This extra return of 5% is the risk premium. Remember that earning the risk premium of 5% is not a certainty. If it was, there would not be any risk involved. Earning the risk premium is only a possibility. The investor would be willing to buy HR stock only if it offered the possibility of providing an annual return of 8%.
The risk premium is the additional return over the risk-free rate that an investor can expect to earn if funds are deployed in a risky asset. It is the compensation that an investor hopes to receive for bearing the enhanced risk of holding a risky asset.