What is Risk Premium?
Definition: Risk premium is the returns that investors expect when they risk their money in an investment.
You have probably heard the saying that there is no reward without risk, and that is entirely true, especially in the investment and insurance worlds. Risk premium is a common term used in the investment landscape.
Risk premium is also described as an investment’s rate of return, usually above the guaranteed rate of return or risk-free rate of return. Note that in the investment world, higher-risk investments tend to attract higher returns. The concept of risk premiums is thus common in risky investments, especially in the financial markets.
Every investor that ventures into a high-risk segment understands the danger that comes with such pursuits. However, they also anticipate significant returns from their risky investment. The risk exists due to the uncertain nature that comes with the investments. One can never predict the direction of the markets with 100 percent accuracy, and the markets may go against the trader. On the other hand, the risk premium is often worth pursuing, especially if the investor tries to structure their investment in a manner that allows them to manage the risks such that they maximize their profit-making potential.
The forex market is one of the investment markets that is characterized by high-risk levels and where the risk premium concept comes into play. Traders risk losing their investment, but then they expect attractive compensation in the form of the risk premium. Note that the risk premium is not guaranteed, which means that the investment may fail to yield, or it may result in a loss. One can, therefore, view risk premium as a reward that an investor might receive for investing in a risky venture. It is the reason why investors are willing to invest even when they know that there is a high level of risk involved.
Risk premium calculation requires users first to calculate the risk-free rate of return and also the estimated returns. The latter is the amount of profit that investors anticipate when they invest in a particular investment avenue. Note that the estimated return is just an estimation or forecasted expectation and not one that is guaranteed. The estimated return can either be a positive or negative figure, or in other words, it can be a profit or a loss depending on the investment outcome.
The potential outcomes are multiplied by their probability of occurrence to find the figure for the estimated return. The calculations are then added together. The calculations are important, especially to investors, because they help them to assess the level of risk involved in an investment opportunity. This is important because it helps investors to match the risk premium with the level of risk, to conclude whether the investment is a risk worth taking.
It is quite common for the term ‘risk-free rate’ to pop up whenever there is talk of risk premium. Risk premium refers to the potential profits that an investor stands to earn when they invest in a risky venture. Risk-free rate, on the other hand, refers to an investment’s rate of return when there is little to no likelihood of a financial loss or when returns are guaranteed.
U.S government-backed treasury bills are a good example of an investment option that has a risk-free rate. The fact that they are backed by the government means that they are characterized by low risk, but then the drawback is that they have a low rate of return compared to investment opportunities where a risk premium is involved. Each of them may appeal to different investors. Some of the investors are risk-averse, and so they would more likely be attracted to a risk-free rate while investors with a high-risk appetite are likely to invest in investments with a risk premium.