In this post, we’ll unpack all you need to know about risk premium, defining exactly what it is, the factors that influence it, how to calculate it, why it’s important and more.
What Is Risk Premium?
The phrase Risk Premium (RP) refers to the additional yield an investor expects to earn from an investment above the risk-free rate as compensation for increased risk.
What Factors Influence Risk Premium?
There are several factors that can influence Risk Premium, including risk tolerance, macroeconomic conditions, market volatility and the specific characteristics of the investment.
More risk-averse investors will likely demand a higher RP. More risk-seeking investors will likely demand a lower RP.
During stable economic periods and low market volatility, the RP may fall due to increased certainty, increased investor confidence and decreased perceived risk. During unstable economic periods and periods of high market volatility, the RP may rise due to decreased certainty, decreased investor confidence and increased perceived risk.
With a low-risk asset, the RP may fall due to decreased perceived risk and therefore decreased potential for capital loss. With a high-risk asset, the RP may rise due to increased perceived risk and therefore increased potential for capital loss.
What Is The Formula For Risk Premium?
To calculate Risk Premium, simply find the difference between the risk-free rate and the expected return of a specific asset.
Mathematically, the calculation is expressed as: Risk Premium = Estimated Return On Investment – Risk-Free Rate.
There are two alternative ways to estimate RP. Firstly, historical Risk Premium which calculates the expected return based on past returns on stocks versus risk-free investments. This method is backward-looking and can be error-prone. Secondly, implied premium which calculates the expected return based on existing market conditions. This method is forward-looking and dynamic.
Why It’s Important
Understanding Risk Premium is essential for making informed investment decisions.
The Risk Premium is crucial for assessing the viability of potential investment opportunities.
It allows investors to quantify the excess return they require for choosing a riskier investment over a risk-free one. This in turn helps determine whether the potential return of an asset justifies the risk involved.
A well-calculated RP can also guide portfolio management, helping to balance the mix of assets to achieve desired returns while managing risk.
It is also an essential component when generating a Discounted Cash Flow.
Summary (TL;DR)
The phrase Risk Premium refers to the additional yield an investor expects to earn from an investment above the risk-free rate as compensation for increased risk.
The RP is calculated by determining the difference between the risk-free rate and the expected return of a specific asset.
Factors that can influence RP include risk tolerance, macroeconomic conditions, market volatility and the specific characteristics of the investment.
By gaining a clear understanding of RP, investors are able to make more informed investment decisions, ultimately leading to increased investment success.
