Risk premium is any return above the risk-free rate. The risk-free rate refers to the rate of return on a theoretically riskless asset or investment, such as a government bond. All other financial investments entail some degree of risk, and the return on the investment above the risk-free rate is called the risk premium.
When an investor purchases a financial instrument, such as stock or bonds, that investor is putting his capital at risk. The company that issued the stock could perform poorly and its stock could plummet in value; or the company issuing the bonds could default and its bonds could become worthless. Both of these potential scenarios represent risk for the investor or speculator. The return on an investment, which corresponds to the riskiness of the investment, is supposed to compensate the investor for that risk.
Different financial instruments have different degrees of riskiness and the returns on these instruments typically correspond with the level of risk. More risky assets have higher returns; less risky assets have lower returns. An asset with no risk, such as a U.S. government bond, has a comparatively low rate of return because there is little or no risk of the U.S. government defaulting. Therefore, the rate of return on that type of riskless asset is referred to as the risk-free rate. Any return above that rate is a risk premium which compensates the investor for the riskiness of the asset.
Assume the risk-free rate is 5%. This means a riskless U.S. government treasury bond offers an annual return of 5%. Let’s say an investor invests in the stock of a company and that stock has an annual return of 7%. The risk premium for that company’s stock is the difference between the risk-free rate of 5% and the expected return of the stock of 7%. So the risk premium is 2%.
Risk Premium = Asset Return – Risk-Free Rate
2% = 7% – 5%
The risk premium is also used in calculating the expected return on asset when using the capital asset pricing model (CAPM). In that case, the risk premium combines the market risk premium, or the overall stock market’s return above the risk-free rate, with the beta of the individual stock. This gives the risk premium for the particular stock over the risk-free rate.