Risk premium refers to the difference between the expected return on a portfolio or investment and the certain return on a risk-free security or portfolio. It is the additional return that an investor requires to hold a risky asset rather than one that is risk free. Underlying the term risk premium is the idea that there should be a higher expected return – a premium for bearing risk. Many experts claim that there is no reason why some type of premium should be associated with all types of risk.
In other words, a risk premium is the expected excess return on an investment, where the excess return is the difference between the return of a risk-free security and an actual return.
Risk premium may also be a measure of the extra return that an investor demands to bear risk – a market portfolio’s reward-to-risk ratio.
According to BusinessDictionary.com, risk premium is:
“1. Difference between a risk-free return (such as from government bonds) and the total return from a risky investment (such as equity stock). 2. Additional return or rate of interest (above the market interest rate) an investor requires for investing in a proposition or venture. Also called price of risk.”
How much more is the yield on the Fred’s Café bonds than the US government-issued security? The answer is 3%. US government-issued securities are considered as ‘risk free’, while the Fred’s Café ones carry a considerably greater risk, that is why their yield is double. The 3% difference between the two is the risk premium.
Risk premium – form of compensation
Investors see risk premium as a type of compensation for bearing the additional risk, compared to that of an asset with virtually no risk, in a given investment.
High-quality corporate bonds, for example, those that are issued by established blue-chip companies earning large profits, have the smallest risk of default in the private sector. Such bonds, therefore, pay a lower rate of interest (yield) compared to bonds that less-established commercial enterprises issue; companies with uncertain profitability or a relatively higher risk of default.
If a U.S. government-issued security – which is classed as the most risk-free investment available – pays 3% per year, and that of the less-established firm pays 6%, the risk premium is 6 minus 3, which equals 3%.
Companies that issue bonds, for example, with higher yields, are giving a form of hazard pay to the investors who are willing to bear the greater risk – they get compensation for the risk they undertake.
An investment that is not ‘risk-free’ must have something appealing to attract investors, such as a higher potential rate of return. How much that rate of return is, compared to the much safer bets, is the risk premium.
In a game show, to get a decent number of people to choose Option A – open the door to see what is hidden behind it – rather than take the cash, you need a good risk premium; otherwise most of us would opt for taking the cash. We have a tendency to be risk averse.
Risk premium in a game show
Imagine a game show offers a participant to choose one of two doors: if she opens one door she wins $1,000, but will get $0 if she opens the other.
The contestant is also given the choice of taking no risk and walking away with $500 cash. The two options – choosing between one of the doors or taking $500 – have an identical ** expected value of $500, therefore no risk premium has been offered for choosing the doors instead of taking the guaranteed $500.
** The ‘expected value’ is the sum of what is behind the doors divided by the number of doors. In this case, the expected value is $1000 plus $0 divided by 2, which equals $500.
A risk neutral contestant – one who is insensitive to risk – will be indifferent between the two choices. A risk averse contestant – one who prefers certainties to taking risks – will choose the guaranteed $500. A risk seeking contestant – one who thrives on uncertainty – will choose the two-doors option.
Given that most of us are somewhat risk averse, in order to get more people to choose the two-doors option, the game show organizers will have to offer a greater potential prize behind one of the doors.
According to GuggenheimPartners.com: “The equity risk premium is calculated by subtracting the risk-free rate (real 10-year Treasury yield as a proxy) from the earnings yield of equities (S&P 500 earnings yield as a proxy).” (Image: adapted from guggenheimpartners.com)
If the prize is increased to $1,600, thus raising the expected value of choosing between the two doors to $800, the risk premium becomes: $800 (the expected value) minus $500 (guaranteed), which equals $300.
Participants who require a minimum risk premium smaller than $300 will be more likely to choose the two-doors option rather than the guaranteed $500 if one of the doors has $1,600.
Video – Definition of Risk Premium
This UT McCombs School of Business video explains what risk premium is using simple language, clear examples and easy-to-understand concepts.