What Is a Risk Premium?

A risk premium is the extra return above and beyond the risk-free rate that investors might expect in exchange for taking on extra risk when purchasing a certain asset.

Riskier investments, such as aggressive growth stocks and low-rated bonds, are appealing to investors because they have the potential for higher returns that may compensate for the higher risk of loss. How high that potential return might be will vary depending on how risky the investments are.

Risk premiums are a useful way to help determine the risk-reward ratio of a given investment.

Risk Premium Definition

A risk premium is the return above the so-called risk-free rate that investors expect as compensation for the chance that the investments will lose some or all of their value. It’s often compared to hazard pay on a difficult job, and it can help investors answer the question: Is the potential return of this investment worth the added risk of loss?

Knowing the risk premium can help investors better understand the risk-reward ratio of an investment. If a government bond that’s widely considered to have very little risk pays 3%, then investors wouldn’t take any more risk unless they could expect a higher return, otherwise known as a risk premium.

Investment risk for new investors is an important topic, and one that they should consider when building their portfolios.

If an investor, using an investment calculator, determines that they need a 9% annual return in order to meet their financial goals, they’ll need to take on more risk with investments that pay a higher risk premium.

The Concept of the Risk-Free Rate

The concept of a risk-free rate of return is that it’s the interest that an investor can expect from an investment that comes with zero risk. The risk-free rate is a concept more than a reality, because there’s no way to eliminate risk altogether; all investments include risk, whether you’re investing online or through traditional channels.

In today’s market, investors often consider the interest paid by a 10-year government Treasury note as a proxy for the risk-free rate. It is possible for a highly rated government such as the United States to default, but most investors consider the likelihood of that to be very low.

The rate offered by a10-year Treasury is one example of a risk-free rate, and the general rule when determining the risk-free rate is to look for the most stable government body issuing bonds in a given currency.

Recommended: Stock Market Basics for Beginners

How to Calculate the Risk Premium

The most common risk premium considered by investors is the Market Risk Premium (MRP), and it’s one that’s fairly straightforward to calculate, as:

Market Risk Premium = Expected Rate of Return – Risk-Free Rate

Step 1: Determine the Expected Return of the Asset

This first step is possibly the most difficult, because it involves predicting the future. Nothing is guaranteed, especially in the stock market. When calculating this figure, an investor will look at their own personal expectations and requirements, as well as the past average annual returns of the asset, or its sector, or even the broader market index it belongs to. An investor might also want to use a stock profit calculator.

Step 2: Identify the Current Risk-Free Rate

This step is as simple, for U.S. investors, as checking the rate offered by the 10-year U.S. Treasury bond.

Step 3: Subtract the Risk-Free Rate From the Expected Return

Once you’ve subtracted the annual returns of the 10-year Treasury from the expected return of the asset you’re considering, then you have your risk premium.

3 Common Types of Risk Premiums

In addition to the MRP, investors use the concept of a risk premium to look at other risks, including the risk of investing in stocks, the chance that a bond issuer will default, and the cost of not being able to easily sell a given asset.

1. Equity Risk Premium

The equity risk premium, or ERP, is the extra return investors expect to earn in the stock market, above that offered by a risk-free investment such as a U.S. Treasury bond, as noted above. Because it is used as a forward-looking indicator, it’s entirely conceptual. Investors calculate the equity risk premium using past performance, tracking a stock market index versus the return of a risk-free benchmark.

2. Default Risk Premium

The default risk premium is a bond’s or note’s interest rate minus the risk-free rate. It shows how much the borrower behind a debt security (like a government) is willing to pay investors for the risk that it might default on its payments. As such, the default risk premium depends on the creditworthiness of the company, government, or individual issuing the debt security.

3. Liquidity Risk Premium

A liquidity risk premium is the higher return offered by investments that investors can’t quickly sell. It essentially compensates investors for keeping their money tied up in a given investment longer than they might otherwise want. That’s because some investments are easier to sell than others.

T-bills and stocks are considered the standard for liquidity because investors can quickly sell them at any time for the listed market price.

Other investments, such as real estate or equity stakes in private companies, or other types of alternative investments, can take some time to sell. These investments will offer a liquidity risk premium, or an illiquidity premium. They offer higher potential returns because investors can’t sell them quickly in the event of a market downturn, or a sudden need for cash.

Why the Risk Premium Matters for Investors

Investors can use risk premiums to build portfolios and to make a host of decisions. Risk premiums are an important factor in designing diversified portfolios, as it helps investors evaluate differing levels of risk and return in different asset classes.

One key step in investing is to determine your risk tolerance. A wide range of risk premiums in a portfolio can allow investors to achieve their planned level of risk-adjusted returns over time. Risk premiums also help investors compare different asset classes. And investors can also use risk premiums to evaluate the performance of overall portfolios and individual assets over time.

Active investors can use risk premiums as a way to decide which securities to buy and to sell.

The Takeaway

The risk premium is the return offered by an investment above and beyond the return offered by a risk-free asset, such as a 10-year U.S. Treasury bond. It’s more of a theoretical rate than an actual one, but it gives investors a way to gauge how much risk is acceptable.

Investors can also track risk premiums connected to the broader stock market, to the likelihood that a bond issuer will default, and to the relative illiquidity of a given asset.

Investors can track and use risk premiums to plan and build portfolios that match the returns they hope to achieve with the risks they’re willing to take.

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FAQ

What is premium risk in the context of investing?

Premium risk, or risk premium as it’s commonly known, is the extra return that an investment may offer above the so-called risk-free rate of a government bond, in exchange for taking on the risk of losing money.

Are risk premiums guaranteed to be paid out?

No. A risk premium is conceptual, as it’s based on an assumed risk-free rate of return of a more stable asset (such as a government bond) and the potentially higher return of a riskier asset, based on projections and its historical performance.

How does inflation impact the expected risk premium?

Inflation often increases the expected risk premium by increasing economic uncertainty, reducing future purchasing power, and eroding corporate profit margins. As a result, investors demand higher compensation in the form of elevated risk premiums for holding riskier assets.

Can a risk premium ever be negative?

A risk premium can be negative, in both forward-looking market calculations and in historical periods.

Where can I find the current risk-free rate to calculate a premium?

To find the current risk-free rate for a risk premium calculation, use the yield on 10-year government bonds, or bonds that match your cash-flow timeframe.

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Photo credit: iStock/Drazen Zigic

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