What is risk premium?
Those who take on riskier investments are compensated with a greater return. The risk premium is the amount the investor should expect to receive for risking the loss of his or her money for making the investment.
The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return.
To calculate risk premium, investors must first calculate the estimated return and the risk-free rate of return. The estimated return, or the expected return, on a stock refers to the amount of profit or loss that an investor expects from a particular investment.
The estimated return is a projection and is not a guaranteed return. Investors can calculate the estimated return by multiplying the potential outcomes by the percent chance of them occurring and then adding those calculations together.
Calculating the estimated return is one way for investors to assess the risk of an investment.
The risk-free rate is the rate of return on an investment when there is no chance of financial loss. For example, the U.S. government backs Treasury bills, which makes them low risk. However, because the risk is low, the rate of return is also lower than other types of investments.
If the estimated rate of return on the investment is less than the risk-free rate, then the result is a negative risk premium. In these instances, investors would be better off investing in a Treasury bill because the return is both greater and guaranteed.
Risk premium example
The estimated return minus the return on a risk-free investment is equal to the risk premium. For example, if the estimated return on an investment is 6 percent and the risk-free rate is 2 percent, then the risk premium is 4 percent. This is the amount that the investor hopes to earn for making a risky investment.