Different stocks offer different levels of expected return. What causes stock A’s expected return to be higher than stock B’s expected return? How does the expected return on a risky asset relate to the risk-free rate of return? In this post, we answer both questions by introducing the concept of risk premium.
Risk premium definition
The risk premium for a security (e.g., stock, bond, etc.) can be defined as the return the security generates over the risk-free rate of return. For example, if the yields on government bonds are 3%, and a stock is expected to return 8%, then the risk premium for the stock is 8% − 3% = 5%. Of course, the stock may actually yield (a lot) more or less than 8%, hence the risk premium.
More generally, if the expected return on a risky asset is E[R] and the risk-free rate is Rf, then the risk premium formula is:
For ease of interpretation, we can rewrite this formula as follows:
It tells us that a risky asset’s expected return is equal to the risk-free rate PLUS a risk premium. It implies that we would invest in a risky asset only if it offers a return higher than the risk-free rate. That markup constitutes the risk premium. This is a direct consequence of investors’ aversion to risk: Risk-averse investors would bear risk only if they are rewarded for doing so. And, the risk premium is the reward they receive.
In general, the riskier the asset, the higher the risk premium should be. So, if asset A is riskier than asset B, we have πA > πB. If that is the case, we can deduce that asset A’s expected return, which is E[RA] = Rf + πA, should be higher than asset B’s expected return, which is E[RB] = Rf + πB, as well: E[RA] > E[RB] since πA > πB.
Risk premium calculator
To use the risk premium calculator below, enter (i) the asset’s return, and (ii) the return on the risk-free asset. You might find our CAPM calculator useful as well.
In this lesson, we have offered a definition of risk premium, linking it to the concepts of risk aversion and riskless return. We have also offered a simple risk premium calculator that relies on the asset’s return and the risk-free rate of return.
Chan et al. (1992), ‘Global financial markets and the risk premium on U.S. equity‘ Journal of Financial Economics, Vol. 32(2), pp. 137-167.
what is next?
This lesson is part of our free course on investments.
- Next lesson: We will be moving on to the topic of portfolio theory and will begin with teaching how to calculate portfolio returns.
- Previous lesson: We introduced the risk aversion coefficient as a means for quantifying an individual’s degree of risk aversion.
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