Definition: Risk premium represents the extra return above the risk-free rate that an investor needs in order to be compensated for the risk of a certain investment. In other words, the riskier the investment, the higher the return the investor needs.
What Does Risk Premium Mean?
What is the definition of risk premium? The concept of a risk premium is used mostly by investors and finance students studying and dealing with the financial markets. Specifically, it is usually applied to equities and companies as a measure of how much the potential investor needs to be compensated to take on the extra risk when compared to a “risk-free” investment, which is usually the US 10 year Treasury. It is also used to measure the riskiness of a company or industry during a valuation, where smaller companies have a higher premium than a larger, more established, company.
Let’s look at an example.
Example
John is thinking about investing his life savings of $50,000 in order to earn an attractive return. However, he is very conscious of risk due to the recent financial crisis, and wants a satisfactory balance between risk and return. He starts out by conducting some research to answer his questions: What is the least risky investment? What is an extremely risky investment? What kinds of returns do they have? How can he calculate which investment to choose?
He discovers that one of the least risky investments is the US Treasury Bond, which is considered practically “risk-free” as it is backed by the government, and thus gives a 3% return with no premium. He also found that one of the most risky investments, a stock of a cyclical and mismanaged mining company, provides a 25% return, which equates to a 25% – 3% = 22% premium. However, he digs into the company and sees it is prone to larger swings in price and fortunes; in other words, it is a very unstable investment.
John digs into the two investment options, and discovers the reason that the mining company’s return is much higher than the US Treasury Bond’s return is because investors need to be compensated in the form of higher possible returns for the increased chance of losing their money. This is called the risk premium, and is an important concept in determining an investment plan.
Summary Definition
Define Risk Premiums: Risk premium means the additional return that investors expect from an based on its level of risk.
