Risk premium refers to the reward amount for holding a risky investment rather than a risk-free investment. The risk premium can also be defined as the difference between the return rate and the risk free return rate. Risk premiums are calculated for a single security, a basket of securities or even for the entire market.
The risk premiums calculated for markets are known as the market risk premiums and are important for the securities valuation models like CAPM (capital asset pricing model). In other words, risk premium can also be defined as the minimum difference between the expected value and the unknown certain value of an uncertain bet.
The risk premium of securities like shares is considered without any doubt. In finance, the risk premium is defined as the expected rate of return based on the interest rate that is risk-free in nature. The most common approach towards the measurement of risk is to compare the returns that are virtually risk free and other returns that are very risky. The difference that comes out can be represented as the excess return measured on the average risky assets.
The excess return that is obtained is called as the risk premium.
The risk premium has different definition in the debt theory. In terms of the bonds, the risk premium is referred to as the credit spread, which is better explained as the difference between the risk-free rate and interest rate of the bond.
In terms of the equity market, risk premium refers to the amount that comes from subtracting the risk-free rate from the return of a particular company stock or the return of a group of company stocks or the return of even all the market stocks. The return earned from equity is also referred as the capital gains or dividend yield. The risk premium for the equities is often called as the equity premium.
The concept of risk premium is highly used in the game theories. In cases of the games where the contestant is exposed to more than one choice, the risk premium concept is highly applicable.
Last Updated on : 1st July 2013