Risk Premium

A risk premium is the return in excess of the risk-free rate of return an investment is expected to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment. For example, high-quality corporate bonds issued by established corporations earning large profits typically have very little risk of default. Therefore, such bonds pay a lower interest rate, or yield, than bonds issued by less-established companies with uncertain profitability and relatively higher default risk.

Think of a risk premium as a form of hazard pay for your investments. Just as employees who have relatively dangerous jobs receive hazard pay as compensation for the risks they undertake, risky investments must provide an investor with the potential for larger returns to compensate for the risks of the investment.

Investors expect to be properly compensated for the amount of risk they undertake in the form of a risk premium, or additional returns above the rate of return on a risk-free investment such as U.S. government-issued securities. In other words, investors risk losing their money because of the uncertainty of a potential investment failure on the part of the borrower in exchange for receiving extra returns as a reward if the investment is profitable. Therefore, the prospect of earning a risk premium does not mean investors can actually get it because it is possible the borrower may default absent a successful investment outcome.

A risk premium can also be construed as a true earnings reward as some risky investments are inherently more profitable when and if they come through as an investment success. Investments with certainties and predictable outcomes are not likely to become business breakthroughs when already operating in well-penetrated markets. Only novel and risky business and investment initiatives could potentially offer above-average returns the borrower may then use as an earnings reward for investors. This is one underlying incentive that has encouraged some investors to seek riskier investments, knowing there could be potentially bigger payoffs.

A risk premium can be costly for borrowers, especially when their investments are not potentially the most prosperous ones. The more risk premium they pay investors as risk compensation, the more financial burden they may take on, which likely hurts the very success of their investments and increases the chance of a default. With this perspective in mind, it is in the best interest of investors themselves to reconsider the level of risk premium they demand, or else they must be prepared to fight over debt collections in the event of a default. In many borrowing-laden bankruptcies, for example, investors only receive back cents on the dollar on their investment, despite prior promises of a risk premium.

The equity risk premium refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies depending on the level of risk in a particular portfolio and also changes over time as market risk fluctuates. As a rule, high-risk investments are compensated with a higher premium. A majority of economists agree that the concept of an equity risk premium is valid: over the long term, markets compensate investors more for taking on the greater risk of investing in stocks. 

The equity risk premium is can be computed in several ways, but is most often estimated using the capital asset pricing model (CAPM):

where the cost of equity is effectively the equity risk premium. R_f is the risk-free rate of return, and R_m-R_f is the excess return of the market, multiplied by the stock market's beta coefficient.

The second half of the 20th century saw a relatively high equity risk premium, over 8% by some calculations, versus just under 5% for the first half of the century. Given that the century ended at the height of the dot-com bubble, however, this arbitrary window may not be ideal.