Risk Premium – What Is it?

Risk Premium is the amount of return that an investor or lender expects to receive for putting their money at a higher level of risk than what would be generated from a risk-free investment. Risk premium is calculated by subtracting the expected return of a risk-free asset, such as a government bond, from the expected return of an asset that carries a higher level of risk, such as a stock.

The equity risk premium measures the additional return an investor should expect to receive when investing in stocks or equity markets over a risk-free return. It is an important measure of how much of a return an investor should expect from an investment relative to the risk they are taking on.

It is important to note that risk premiums differ across asset classes, as the amount of risk carried by each asset will differ. For example, the equity risk premium for stocks is higher than that of government bonds, as stocks carry more risk. The risk premium for different asset classes is also estimated differently.

Risk premiums are an important consideration when constructing a portfolio. An investor will typically include assets with a risk/return profile that matches their needs. Riskier assets tend to have higher return potential, but also higher volatility and risk of loss. By combining assets with different risk premiums, investors can create a portfolio with a combination of relatively safe and risky assets.

Overall, the risk premium is an important concept for investors to understand. It helps investors determine how much return they can expect from a given investment relative to the amount of risk they are taking. By understanding the concept of risk premium and how different assets can affect it, investors can structure a portfolio that reflects their risk/return preferences.