Risk Premium

Risk Premium is the return in excess of the risk-free rate of return that an investment is expected to yield. An asset’s risk premium is a form of compensation for investors who tolerate the extra risks compared to that of a risk-free rate in a given investment.

Risk Premium Formula
Risk Premium

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Risk Premium Types

  • Default Risk Premium = Investor compensation for Investment’s Default risk
  • Liquidity Risk Premium = Investor compensation for receiving less cash from investment (liquidity risk)
  • Maturity Risk Premium = Investor compensation for increased sensitivity of investment’s market value to change in interest rates (Long-term Bonds are more volatile than Short-term Bonds)

Risk premium exists throughout asset classes and different markets.
Stocks Risk Premium: In the stock market the risk premium is the expected return of a company stock minus the risk-free rate. The return from equity is the sum of the capital gain and dividend yield.

Bonds Risk Premium: In bond markets, Risk-premium includes Default Risk Premium, Liquidity Risk Premium and Maturity Risk Premium. Long-dated bonds yield more than short-dated bonds due to uncertainty of the future. Investors taking the risk of long-dated debt are compensated by this premium because default is always possible.