Risk Premium - Finance

Finance

In finance, the risk premium refers to the amount by which an asset's expected rate of return exceeds the risk-free interest rate. When measuring risk, a common approach is to compare the risk-free return on T-bills and the risky return on other investments (using the ex post return as a proxy for the ex ante expected return). The difference between these two returns can be interpreted as a measure of the excess expected return on the risky asset. This excess expected return is known as the risk premium.

• Equity: In the equity market the risk premium is the expected return of a company stock, a group of company stocks, or a portfolio of all stock market company stocks, minus the risk-free rate. The return from equity is the sum of the dividend yield and capital gains. The risk premium for equities is also called the equity premium. Note that this is an unobservable quantity since no one knows for sure what the expected rate of return on equities is. Nonetheless, most people believe that there is a risk premium built into equities, and this is what encourages investors to place at least some of their money in equities.
• Debt: In the context of bonds, the term "risk premium" is often used imprecisely to refer to the credit spread (the difference between the bond interest rate and the risk-free rate). To see why this is inconsistent with the given definition, imagine that the risk free rate is 3% and XYZ corporate bonds are yielding 10%. Does that mean that the expected return in excess of the risk free rate is 7%? Almost certainly not; after all, there is surely a positive probability of a default, as well as a positive probability of positive or negative capital gains due to fluctuations in the market prices of bonds. In reality, the risk premium (as defined above) is likely to be significantly less than the credit spread; it could even be negative, if the bond's default scenarios are negatively correlated with most other bonds' default scenarios. See Capital asset pricing model.