Risk Premium

What Is a Risk Premium?

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. It represents payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset.

For example, high-quality bonds issued by established corporations earning large profits typically come with little default risk. Therefore, these bonds pay a lower interest rate than bonds issued by less-established companies with uncertain profitability and a higher risk of default. The higher interest rates these less-established companies must pay is how investors are compensated for their higher tolerance of risk.

The Basics of Risk Premia

Think of risk premium as a form of hazard pay for your investments. An employee assigned dangerous work expects to receive hazard pay in compensation for the risks they undertake. It's similar with risky investments. A risky investment must provide the potential for 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 a U.S. government security. The premium rewards investors for the prospect of losing their money in a failing business, and isn't actually earned unless the business succeeds.

A risk premium can be construed as a true earnings reward, because risky investments are inherently more profitable should they succeed. Investments in well-penetrated markets — and which tend to have predictable outcomes — are not likely to change the world. On the other hand, paradigm-shifting breakthroughs are more likely to come from novel and risky initiatives. It's these types of investments that can potentially offer superior returns, which a business owner may then use to reward investors. This one underlying incentive is why some investors seek riskier investments, knowing they can reap potentially bigger payoffs.

Premium Cost

A risk premium can be costly for borrowers, especially those with doubtful prospects. These borrowers must pay investors a higher risk premium in the form of higher interest rates. However, by taking on a greater financial burden, they could be jeopardizing their very chances for success, thus increasing the potential for default.

With this in mind, it is in the best interest of investors to consider how much risk premium they demand. Otherwise, they could find themselves fighting over debt collections in the event of a default. In many debt-laden bankruptcies, investors recoup just a few cents on the dollar on their investment, despite the initial promises of a high risk premium.

While economists acknowledge an equity premium exists in the market, they are equally confused as to why it exists. This is known as the equity premium puzzle.

The Equity Risk Premium

The equity risk premium refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of buying stocks. The size of the premium varies depending on the level of risk in a particular portfolio and also changes over time as market risk fluctuates. As a rule, high-risk investments are compensated with a higher premium. Most economists agree the concept of an equity risk premium is valid: over the long term, markets compensate investors more for taking on the greater risk of investing in stocks. 

The equity risk premium can be computed in several ways, but is often estimated using the capital asset pricing model (CAPM):

CAPM(Cost of equity) = R f + β ( R m − R f ) where: R f = Risk-free rate of return β = Beta coefficient for the stock market R m − R f = Excess return expected from the market \begin{aligned} &\text{CAPM(Cost of equity)} = R_f + \beta ( R_m - R_f ) \\ &\textbf{where:} \\ &R_f = \text{Risk-free rate of return} \\ &\beta = \text{Beta coefficient for the stock market} \\ &R_m - R_f = \text{Excess return expected from the market} \\ \end{aligned} CAPM(Cost of equity)=Rf+β(Rm−Rf)where:Rf=Risk-free rate of returnβ=Beta coefficient for the stock marketRm−Rf=Excess return expected from the market

The cost of equity is effectively the equity risk premium. Rf is the risk-free rate of return, and Rm-Rf is the excess return of the market, multiplied by the stock market's beta coefficient.

From 1926 to 2002, the equity risk premium was relatively high at 8.4%, compared with 4.6% for the 1871-1925 period and 2.9% for the 1802-1870 period. Economists are puzzled as to why the premium has been especially high since 1926. Overall, the equity risk premium has averaged 5.4%.