risk premium

(noun)

A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, or the expected return on a less risky asset, in order to induce an individual to hold the risky asset rather than the risk-free asset.

Related Terms

Examples of risk premium in the following topics:

  • The "Bond Yield Plus Risk Premium" Approach

    • The risk premium on its equity is 4%.
    • The normal historical equity risk premium for all equities has been just over 6%.
    • In general, an equity's risk premium will be between 5% and 7%.
    • Common methods for estimating the equity risk premium include:
    • Describe the process for the bond yield plus risk premium approach

  • The Cost of Common Equity

    • -- Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.
    • The CAPM shows that the cost of equity is equal to the risk free rate plus a premium expected for risk.
    • Another approach to calculating the cost of common stock is to add a risk premium to the cost of debt.
    • The risk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders, given the amount of risk carried by the equity.
    • Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.

  • Default Risk and Bond Price

    • Economists call the difference between the interest rate on the U.S. government bonds and corporate bonds the default risk premium.Investors add default risk premium to a risk-free investment, so they can invest in "risky" bonds because they earn a greater return.
    • Risk premium is always positive.
    • As the default risk increases, then the risk premium increases too.
    • During recessions, when some businesses bankrupt, the default risk increases, increasing the risk premium.
    • Impact of a risk premium on the bond markets

  • Expected Risk and Risk Premium

    • Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.
    • Systemic risk is the risk associated with an entire financial system or entire market.
    • On the other hand, unsystematic risk is risk to which only specific classes of securities or industries are vulnerable.
    • The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate.
    • The risk premium, along with the risk-free rate and the asset's Beta, is used as an input in popular asset valuation techniques, such as the Capital Asset Pricing Model.

  • Measuring Country Risk

    • Consequently, the interest rate is comprised of the risk-free interest rate and risk premium.
    • Finally, the risk premium reflects a borrower's credit risk.
    • For example, we add a risk premium to calculate the yield on Mexican government bonds.In this case, the risk premium reflects the creditworthiness of the Mexican government and not the country's risk for investing in Mexico.
    • Spread becomes the risk premium, and the 140 basis points equal 1.40%, or 140 ÷ 100.
    • If a country possesses a low score, then analysts and economists would add a large risk premium to the risk-free interest rate.

  • The Term Structure

    • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
    • Shortcomings of the expectations theory is that it neglects the risks inherent in investing in bonds, namely interest rate risk and reinvestment rate risk.
    • This is called the term premium or the liquidity premium.
    • This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
    • Long-term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long-term.

  • Impact of Diversification on Risk and Return: Systematic Risk

    • As a result, the portion of risk that is unsystematic -- or risk that can be diversified away -- does not require additional compensation in terms of expected return.
    • This type of risk cannot be diversified away, and is referred to as systematic risk.
    • This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
    • This risk is present regardless of the amount of diversification undertaken by an investor.
    • Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.

  • Problems with WACC

    • For example, to calculate the cost of equity we have at least three methods we can use - the dividend growth model, the capital asset pricing model, and the bond yield plus risk premium method.
    • To calculate cost of debt, we add a default premium to the risk-free rate.
    • This default premium is the return in excess of the risk free rate that a bond must yield.
    • It will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises) .
    • Risk-free rates are typically approximated from U.S.

  • Defining the Security Market Line

    • The Y-intercept of the SML is equal to the risk-free interest rate.
    • Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
    • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.
    • The idea of a security market line follows from the ideas asserted in the last section, which is that investors are naturally risk averse, and a premium is expected to offset the volatility of a risky investment.
    • The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

  • Inflation Premium

    • An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation.
    • In addition, they will want to be compensated for the risks of the money having less purchasing power when the loan is repaid.
    • These risks are systematic risks, regulatory risks and inflationary risks.
    • The inflation premium will compensate for the third risk, so investors seek this premium to compensate for the erosion in the value of their capital, due to inflation.
    • In the Fisher equation, π is the inflation premium.