What Is Risk Premium?
The higher return an investor will earn or expects from keeping a risky investment portfolio rather than risk-free assets is defined as the risk premium.
A risk premium for your assets is a type of hazard compensation. To compensate an investor for the risk of losing some or all of their cash, there must be a hazardous venture that must provide the possibility of higher returns.
This remuneration is in the form of a risk premium, which is the additional return above and above what may be earned risk-free from assets like US government securities. The premium compensates investors for the risk of losing money in a failed company, and it is not earned until the company succeeds.
To determine the risk premium in a market, you must consider the historical risk premium, expected market risk premium, and the required market risk premium.
Risk premium (RP) and market risk premium (MRP) are two different things (MRP). The term “market risk premium” refers to the additional return you get on non-risk-free assets. Stocks and the projected stock return above the risk-free rate are the risk premium, also known as the equity risk premium.
Furthermore, you can easily calculate the risk premium with the formula below:
Risk premium (RP) = Expected Rate return – Risk-free rate
The amount of profit or loss that an investor anticipates from a given investment is the expected return on a stock. The expected return is a forecast, not a guarantee.
The risk-free rate of return is the rate of return on investment when there is no danger of losing money.
A negative risk premium is created when the expected rate of return on the investment is lower than the risk-free rate.
Risk Premium Example
The Flicker firm produced a 15 percent return the previous year, and the current Treasury bill interest rate is 6 percent. From the previously given formula:
Risk Premium= Expected rate return – Risk-free rate
Expected rate of return = 15%
Risk free rate = 6%
Risk Premium = 15% – 6% = 9%« Back to Glossary Index