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What is risk premium?

If you’re thinking of making an investment in any asset, you’ll be more than interested in working out the return you can expect. The riskier the investment, the more money you should expect back. It’s a simple logic that anyone who’s bet on a sporting event will understand. A sure thing doesn’t pay out as much as a long shot. When businesses decide to invest the financial advisors will run what’s known as a risk premium calculation. So what is risk premium and how is it worked out?
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Definition

Risk premium is the difference between the expected return on a risky investment and the same level of investment on a risk-free one. The risk premium has to be high enough to induce investors to part with their cash rather than putting it in the far safer bet.

Equation

Working it out probably isn’t your job. You wouldn’t be reading a guide about it online if you were responsible for calculating risk premium, but as an investor it’s important to know how it’s worked out. To put it into layman’s terms, the risk premium is a figure that has to exceed the expected rate of return a firm will receive from a risk-free investment, but the way it’s handled differs if you’re looking at equity or debt.

Equity

In the stock market, the expected return on a company’s stock is used as the basis of the risk premium calculation. This is sometimes also called the equity premium to differentiate it from other forms of risk premium. The differentiation is required because unlike most assets, no one really knows what stock will be worth over a given period of time.

Debts

The term risk premium is used to refer to credit spread when you’re dealing with debts rather than assets. That’s a mistake. Credit spread is the difference between the interest rate and the risk-free rate. As there’s always the chance that the debtors default on payment, and because interest rates change with time, the risk premium is normally less than the credit spread figure.

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