Understanding Risk Premium In Detail

Meaning Of Risk Premium

A risk premium is the excess of the risk-free rate of return on an investment that is expected to be generated by a particular asset. The risk premium associated with an asset is a form of compensation for investors. It is a compensation to investors for tolerating the additional risk associated with a particular investment over and above the risk associated with a risk-free asset.

The default risk associated with high-quality bonds issued by well-established corporations that generate large profits, for example, is typically very low. This results in lower interest rates being paid on these bonds than on bonds issued by smaller, less-established companies with uncertain profitability and a higher risk of default. The higher interest rates that these less-established companies must pay serve as a means of compensating investors for their greater willingness to take risks.

There are many different types of risks, including financial risk, physical risk, and reputational risk, among others. If the concept of risk premium can be applied to all of these risks, the expected payoff from these risks can be calculated if the risk premium can be quantified. If the risk premium cannot be quantified, the expected payoff from these risks cannot be calculated. The magnitude of the standard deviation from the mean can be used to estimate the riskiness of a stock in the stock market. Example: If the price of two different stocks is plotted over a year and an average trend line is added for each, the stock with a price that deviates the most significantly from the mean is considered the riskier stock. Other factors about a company that may influence its risk, such as industry volatility, cash flows, debt, and other market threats, are also taken into consideration by analysts and investors.


What Are the Components of a Risk Premium?


Business Risk: When a company's future cash flows are uncertain, business risk is associated with it. This risk is influenced by both the company's internal operations and the environment in which it operates. Increased uncertainty is caused by the variation in cash flow from one period to the next, which results in the need for investors to pay an increased risk premium to compensate for this variation. Company cash flows that are consistent over time, such as those generated by technology companies, require less compensation for business risk than companies whose cash flows vary from quarter to quarter, such as those generated by financial institutions. The more volatile a company's cash flow is, the greater the amount of compensation it must provide to investors.


Financial Risk: It is the risk associated with a company's ability to manage the financing of its operations that we are talking about here. Financial risk, in its most basic definition, is the company's ability to meet its debt obligations. The greater the number of obligations a company has, the greater the financial risk it faces, and the greater the amount of compensation required by investors. Equities-financed companies are not exposed to financial risk because they have no debt and, as a result, no debt obligations. Companies take on debt in order to increase their financial leverage; using outside money to finance operations is attractive due to the low cost of borrowing money from outside sources.


Liquidity Risk : When it comes to exiting an investment, liquidity risk refers to the risk associated with the uncertainty of doing so in a timely and cost-effective manner. The ability to exit a financial investment quickly and at a low cost is highly dependent on the type of security that is held by the investor. A blue-chip stock, for example, is very easy to sell because millions of shares are traded each day and there is a small bid-ask spread between the bid and the ask price. Small-cap stocks, on the other hand, tend to trade in small lots of thousands of shares and have bid-ask spreads that can be as wide as 2 percent. The greater the amount of time it takes to exit a position or the greater the cost of selling out of a position, the greater the amount of risk premium that investors will demand from their investments.