What is Risk Premium and How it Affects Returns?
Risk premium is the minimum incentive people are willing to accept as compensation for investing in volatile investment vehicles. Securities that large and stable corporations issue do not involve high-risk premiums as investors do not need the assurance to invest as they know they will be paid. However, newer and unstable companies tend to offer higher risk premiums to attract more investors.
Read on to learn how risk premium works and how to calculate it.
What is Risk Premium?
A risk premium is a higher rate of return that an investor can expect to earn from riskier assets. Risk premium is like compensation for an investor. For example, if you invest in risky assets like stocks, an investor is expected to yield more than risk-free assets like government bonds.
When you invest in an asset, there are chances or risks that your asset will perform badly, and you will lose money. Share prices may decline due to plenty of reasons like market conditions, poor financial performance or mismanagement. Riskier investments offer the potential for higher returns to the investors.
How Does Risk Premium Work?
A risk premium is like a hazard pay for your risky investment. If you are assigned to do some dangerous job, you will expect compensation for undertaking such risk. It is the same for investments as well.
A risky investment will have a better potential to offer higher returns as compensation for taking the risk of losing a part of your capital or whole of it.
Risk premium comes in the form of additional returns above what investors can earn from government securities. Investors usually take risk in the first place as they know these investments can reap better returns if they succeed.
Investments that have predictable outcomes do not usually give you unexpected returns. Instead, risky initiatives have the potential to offer superior returns. These superior returns help businesses reward equity investors.
How is the Risk Premium Calculated?
Risk premium is calculated by subtracting risk-free rate from estimated asset or investment return. Here, risk-free rate is the return rate an investor earns when they invest in a risk-free asset. On the other hand, estimated asset or investment return is the rate of return an investor expects to receive from risky investments.
The risk premium formula is as follows:
Risk Premium = Ra – Rf
This formula depicts the return that an investor expects for taking additional risk. Hence, to find out additional return for additional risk, both risk-free rate and return rate of the asset for investment must be known. However, this formula only helps get a rough estimate of risk premium, as market values can change at any moment.
Apart from the above-mentioned technique, you can also use risk premium calculators that are available on various online platforms.
Example of Risk Premium
Let’s say that Hari wants to invest Rs.1,00,000 for the best returns he can get. He has the option to invest in government securities like Treasury Bills that, let’s say, are offering a low rate of return of only 2%. On the other hand, he also has the option to invest in stocks that may give him returns of up to 15%.
In case he decides to invest in stocks, he can calculate the risk premium for taking extra risks associated with equities. By using the formula mentioned above, Hari’s risk premium will be:
Risk Premium = Ra – Rf
= (1,00,000 x 15/100) – (1,00,000 x 2/100) = 15,000 – 2,000 = Rs. 13,000
Hence, in this case, Hari will enjoy a Rs.13,000 risk premium if he invests in stocks rather than investing in risk-free investments. This, however, is subject to the positive performance of the stocks. Therefore, Hari needs to understand the risk factors associated with stocks before going ahead with the investment.
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What are the Types of Risk Premiums?
There are a few categories of risk premiums that are prevalent in the market:
• Liquidity Risk Premium
The investors request this type of premium in exchange for being given illiquid securities. This means these securities cannot be converted into cash at market value.
• Country Risk Premium
This is the additional risk that investors face when investing in international companies instead of in domestic markets. In addition, a number of factors, like changes in exchange rates and political instability, come into play when dealing with international investments.
• Equity Risk Premium
It is the excess return that an investor hopes to get when they invest in stocks rather than investing in low-risk options. This can only be estimated as there is no certainty of how the equity stocks will fare.
• Market Risk Premium
This is the difference between the expected returns on a market stock portfolio and the return on risk-free investment options. It is calculated by looking at the slope of the security market line, which is a capital asset pricing model graph.
1. What is Equity Risk Premium?
The equity risk premium represents the incremental risk concerning an equity stock that the investors take with the expectation of getting excess return over the risk-free rate. This excess return compensates investors for taking a relatively higher risk of investing in equities.
The premium depends on the level of risk in a particular portfolio and is subject to change.
a) Equity Risk Premium (ERP) Formula
The equity risk premium formula that is used for calculation is as follows:
Equity Risk Premium (ERP) = Expected Market Return – Risk-Free Rate
This formula helps calculate the difference between the return from the riskier stock market and the returns on risk-free assets with comparable time horizons to compensate investors for the added risk.
b) How to Calculate the Equity Risk Premium (ERP)?
The equity risk premium is calculated by subtracting the return of risk-free securities, such as treasury bills, from the rate of return of riskier equity investments, such as stocks.
PSU bonds, debt instruments issued by central and state government bodies, are almost risk-free. This is because they are government-backed. A rational investor will not accept greater risk in the form of potential loss of invested capital without receiving a higher rate of return.
In case the potential incentive or compensation is not adequate for the investor, owning equities instead of government bonds is not justifiable. Usually, equity securities come with more uncertainties regarding investment outcomes.
2. What is Market Risk Premium?
Market risk premium is the additional return investors receive or expect to receive for holding risky market portfolios rather than risk-free ones. It is a part of the Capital Asset Pricing Model (CAPM) that investors and analysts use to calculate the acceptable rate of return for an investment.
The most important concept of CAPM is the concept of risk. Market risk premium is much broader and diversified in comparison to equity risk premium.
a) Market Premium Formula
The market risk premium formula is provided below:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate of Return
Other than using the formula, you can also use the market risk premium calculator or use the formula in excel.
b) How to Calculate the Market Risk Premium?
The market risk premium can be calculated by finding the difference between expected price return and risk-free rate of return. This will help provide a quantitative measure of extra return that the market participants demand for the increased risk.
For example, if an investor invests in a portfolio and expects a 12% rate of return while the government bond offers a 4% return, the market risk premium will be 12% – 4% = 8%.
How Does a Higher Risk Premium Affect Consumers?
If the risk premium of a government debt security increases, consumers tend to be more doubtful about the country’s ability to return the principal amount as well as the accumulated interest. Additionally, as the rate of interest increases, it becomes more expensive for the country to raise money as it needs to pay higher interest on its debts.
In such cases, the government will make major adjustments like tax hikes to raise revenue and spending cuts. As a result, the economy will most probably lag, which may affect prices, employment, investment, wages, consumption, etc.
Difference Between Market Risk Premium and Equity Risk Premium
The primary difference between market-risk premium and equity risk premium is:
| Market Risk Premium | Equity Risk Premium |
| It is the additional return that an investor expects on a portfolio of investments above the given risk-free rate of return. | This exclusively pertains to stocks and represents the additional return of the stock above risk-free returns. |
| The market risk premium is a quantitative measure that can be calculated by subtracting the risk-free rate from the expected equity market return. | Equity risk premiums can fluctuate depending on the overall economic conditions of a country. |
Final Word
Risk premium is particularly important in case there is economic uncertainty in an organisation. The lesser the investors are certain about a company, the higher the risk premium will have to be. Risk premium works as a reward to persuade investors to take a risk. However, market price fluctuates every second; hence, you must analyse thoroughly before investing for greater risk premiums.
FAQs
Ans: Capital Asset Pricing Model helps calculate investment risks and what return on investment an investor should expect. It describes the relationship between systematic risks, general perils of investing and expected returns from stocks in particular.
Ans: Three primary concepts are used to determine the premium. The first one is the minimum amount the investor should expect. Second is the return’s past investment performance, and lastly, the investor’s return expectations.
Ans: Countries issue public debt bonds to avail investments from people, organisations and other countries. However, the country will have to offer a higher return amidst economic uncertainties to attract more investors. This is a country’s risk premium.
Ans: Market risk premium will impact the level of risk of an investment. It will vary depending on the types of assets the investors are investing in. For example, while equities are riskier options, cash-like instruments and government bonds are considered low-risk options.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.Disclaimer
