A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return. An asset’s risk premium is a form of compensation for investors, representing payment for tolerating the extra risk in a given investment over that of a risk-free asset.
Understanding Risk Premium with Examples
For instance, compare two types of bonds: high-quality bonds issued by established corporations typically come with little default risk and pay a lower interest rate. In contrast, bonds from less-established companies with uncertain profitability must offer higher interest rates due to their greater default risk. Here, the higher interest rates serve as the risk premium, compensating investors for their higher tolerance of risk.
Key Takeaways
- A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return.
- Investors expect to be compensated for the risk they undertake in the form of a risk premium.
- Equity risk premium compensates investors for taking on the higher risk of buying stocks.
- Over the long term, markets have historically averaged a risk premium of around 5% for equities in the U.S.
How a Risk Premium Works
Think of risk premium as hazard pay for your investments. A risky investment must promise potential larger returns to compensate an investor for the risk of losing some or all of their capital.
This compensation comes in the form of a risk premium, which is the additional returns above what investors can earn risk-free from investments such as U.S. government securities. This premium isn’t earned unless the business succeeds, thus rewarding investors for the prospect of losing their money.
The Costs of Risk Premium
Risk premium can be costly for borrowers with doubtful prospects because they must pay this premium in the form of higher interest rates. Therefore, it is crucial for investors to judiciously consider how much risk premium they ask for to mitigate potential losses if the borrower defaults.
The Equity Risk Premium (ERP)
The Equity Risk Premium refers to the excess return from investing in the stock market compared to the risk-free rate. The size of this premium varies depending on the portfolio risk level and market conditions and is often calculated using the Capital Asset Pricing Model (CAPM):
1\text{CAPM(Cost of equity)} = R_f + \beta ( R_m - R_f )
Where:
- R~f~: Risk-free rate of return
- Beta: Beta coefficient for the stock market
- R~m~-R~f~: Excess return expected from the market
From 1928 to 2022, the U.S. ERP averaged about 5.06%. As of early 2023, it stood at 4.77%, signaling variations due to market conditions, interest rates, and other factors.
Current Equity Risk Premium
Recent data suggest that the equity risk premium stood at 4.77% at the beginning of May 2023, slightly below the average and a drop from earlier in the year. This fluctuation reflects changes in market valuation and interest rates.
What Is the Risk Premium for an Investment?
The risk premium for an investment is the extra amount you’re expected to earn for taking on extra risk. For instance, if a safe investment yields 3% and a riskier investment yields 8%, the risk premium is 5%.
How Is Risk Premium Calculated?
The risk premium can be calculated by subtracting the return of a risk-free investment from that of a risky investment. The resulting figure represents the compensation for taking on the additional risk.
The Bottom Line
Higher risk of capital loss demands higher compensation in the form of a risk premium. Across nearly a century, the U.S. equity market’s risk premium has averaged about 5%, but an elevated equity risk premium doesn’t always indicate a buying opportunity, nor does a lower premium signal a need to sell. Investors should always weigh the risk against the potential reward.
Related Terms: Risk-free rate, Equity Risk Premium, Capital Asset Pricing Model, Default Risk.
References
- Forbes. “You Need to Understand the ‘Equity Risk Premium’”.
- Stern School of Business. “Equity Risk Premiums (ERP): Determinants, Estimation, and Implications – The 2023 Edition Updated: March 23, 2023”, Page 103
- Universidad Francisco Marroquín. “The equity premium in 150 textbooks”.
- Wharton University of Pennsyvania. “The Historical Market Risk Premium: The Very Long Run”.
- J. Siegel, jeremy, and Richard H. Thaler. Anomalies: The Equity PremiumPuzzle. Journal of Economic Perspectives, vol. 11, no. 1, 1997, pp 191-200.
- Statista. “Average market risk premium in the United States from 2011 to 2022”.
- Wharton University of Pennsyvania. “The Historical Market Risk Premium: The Very Long Run”.
- Stern School of Business. “Damodaran Online”.
- Aswath Damodaran Blog. “Data Update 3 for 2023: Inflation and Interest Rates”.
