risk premium

(noun)

The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

Related Terms

Examples of risk premium in the following topics:

  • Measuring and Managing Risk

    • Therefore, investment returns compensate holders for the time to maturity via a risk premium .
    • Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment.
    • The differential in yield can be attributed to a risk premium for time to maturity.
    • Another aspect of time horizon is reinvestment risk.
    • To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.

  • The Relationship Between Risk and Return and the Security Market Line

    • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
    • For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class .
    • The market risk premium is determined from the slope of the SML.
    • The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm)− Rf.
    • If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk.

  • The Value of Diversification

    • However, all investments have some degree of risk in meeting the stated investment objectives or return.
    • The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset.
    • It's important to note that diversification does not remove all of the risk from the portfolio.
    • Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk).
    • Systematic risk will affect the portfolio, regardless of how diversified it is.

  • Social Insurance

    • Social insurance has been defined as a program where risks are transferred to and pooled by an organization (often governmental) that is legally required to provide certain benefits.
    • It is funded by taxes or premiums paid by (or on behalf of) participants (although additional sources of funding may be provided as well); and
    • Medicare is funded through revenue from FICA and SECA payroll taxes, as well as through premiums paid by Medicare enrollees and general fund revenue from the federal government.

  • Impacts of Surpluses and Shortages on Market Equilibrium

    • There are substantial business risks inherently built into the concept of surpluses, as the general outcome will be either selling off inventory at sub-par prices or leftover unsold inventory.
    • It could also indicate that the desired good has a low level of affordability by the general public, and can be a dangerous societal risk for necessary commodities.
    • This will prioritize who receives the good or service based upon their willingness and ability to pay a premium for the specific item in demand, leveraging those along the demand curve who are at higher levels with higher ability and willingness to pay.

  • The Special Case of Banking

    • The government's bank-insurance agency, known as the Federal Deposit Insurance Corporation, pays off the depositors, using funds collected as insurance premiums from the banks themselves.
    • To protect the government from undue financial risk, regulators supervise banks and order corrective action if the banks are found to be taking undue risks.
    • Prior to the Depression, many banks ran into trouble because they took excessive risks in the stock market or provided loans to industrial companies in which bank directors or officers had personal investments.

  • Analysis of Price Discrimination

    • Premium pricing: uses price discrimination to price products higher than the marginal cost of production.
    • Regular coffee is priced at $1 while premium coffee is $2.50.

  • Disposable Income

    • For the purposes of calculating the amount of income subject to garnishment, United States federal law defines disposable income as an individual's compensation (including salary, overtime, bonuses, commission, and paid leave) after the deduction of health insurance premiums and any amounts required to be deducted by law.

  • Elasticity Conditions for Price Discrimination

    • Premium pricing: premium products are priced at a level that is well beyond their marginal cost.
    • For example, a regular cup of coffee might be priced at $1, while a premium coffee is $2.50.

  • Institutions, Markets, and Intermediaries

    • Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles and through creating loans of varying lengths from investor monies or demand deposits, these intermediaries are able to convert short-term liabilities to assets of varying maturities.
    • Additionally, through diversified lending practices, banks are able to lend monies to high-risk entities and by pooling with low-risk loans are able to gain in yield while implementing risk management.