Risk Premium

Risk premium is the return from investment which is higher than the risk-free asset. It is the return for investors who facing a higher risk of the investment.

It is the additional reward which compensates on the extra risk which we need to face otherwise, we should invest in a risk free asset.=

Investors use risk premiums to balance with the extra risk and decide whether to invest or not. If the risk premium is too low compare to the risk, investors may decide to go with risk-free investment.

Risk-free investment/asset refers to the zero risk investment such as government bond, state bond or similar instruments. This kind of investment contains almost zero risks but they provide such a low return.

Risk Premium Formula

Risk Premium = Return on Asset – Risk-Free Return

Risk Premium Example

Company A is considered to invest $ 50,000 in a new project which can provide a return of 15% per year. On the other hand, they can invest in government bonds which is the risk-free asset with a return of 5% per year.

Please calculate the risk premium for company A.

Risk Premium = Return on Asset – Risk-Free Return

= ( $ 50,000 * 15%) – ($50,000 * 5%)

= 7,500 – 2,500 = 5,000

It means the company receives a risk premium of $ 5,000 if they invest in a higher risk project rather than risk-free assets (government bond). It is a reward for them to net off with the risk involved. They can compare the reward and risk before making a decision. If the risk is far higher than the reward, they may decide to select the risk-free investment.

Risk-free Asset

We have talked a lot regarding risk-free assets in this article. So what exactly is it? We consider government bonds or debt is the most secure one especially the US government. The government needs to run and they almost impossible to go bankrupt. They will manage to pay back the debt in any circumstance. As they are able to borrow from the central bank or print more money. So government security is to consider the most secure investment.