Risk premium: what is it and how to calculate it

Every investment carries a certain risk level, a fundamental component that an investor must weigh up carefully before deciding whether to invest.

Investors are compensated for taking this risk through a risk premium. This is an expected return from their investment, over and above the return they might get had they taken no risk with their money.

As the risk premium is an expected return, the investor has no certainty they will actually receive this compensation.

Precisely, the meaning of risk premium is the expected compensation from an investment beyond the risk-free return. In other words, if a risk-free investment offers a certain return, the risk premium is an expected additional return for the investor who takes on a specific risk.

Of course, all investments have a risk component, which is why any investment offers a certain risk premium. It is a kind of risk indemnity, compensation for the investor who has chosen to take on a certain risk by making an investment.

There are different types of risk premiums. The equity risk premium is the return offered from shares over bonds for the higher risk they entail, even when the issuer of the two financial instruments is the same.

If a listed company issues both shares and bonds, the equity risk premium for that issuer is the additional remuneration expected by those who invest in the shares and not in the bonds because they take on more risk.

Many government bonds (like US T-Bills) are regarded as risk-free investments, so the equity risk premium in general market terms is the expected return offered by equity investments that is higher than the return on government bonds, to compensate for the higher risk of holding them.

The market risk premium is the return that, on average, investments in a particular market are expected to provide against a certain risk. Specifically, it’s the return that an investor investing in a market can expect, calculated on the basis of historical investment returns.

For example, the UK market risk premium in 2021 averaged 5.7%, so investors who took on the risk of investing in the UK market received an average return of 5.7%. According to professional assessments, the market risk premium in the US was 5.5% over the same period.

There are various methods to calculate the risk premium; one of the most widely used to calculate the equity risk premium is the Capital Asset Pricing Model (CAPM). Using CAPM, you calculate the difference between the expected return on stocks and bonds (R - R), multiplying the result by a coefficient (β) and adding the risk-free rate of return (R).

• R + β (R - R)

As an example to illustrate, if a ‘risk-free’ investment in UK government bonds offers a return of 2%, while an equity investment in a company listed on the FTSE 100 of the London Stock Exchange offers a return of 6%, this means that the investor expects a risk premium of 4%. The investor therefore expects to earn 4% from that investment (the difference between the expected return of the chosen instrument and that of an investment they could have made ‘risk-free’).

You should always carefully assess the risk premium of an investment, and avoid analysing only its expected total return and the risk factors. For example, an investment offering a return of 10% has a lower risk premium if government bonds provide a return of 6%, whereas it will be higher if the government bond return is 2%. In the first case, the risk premium will be 4% and in the second 8%, while the absolute return on the investment remains 10%.

The risk premium helps you to consider investments not only individually, but also compared to the risk/return ratio for a risk-free investment. This in turn helps you to choose investments more consciously and assess various opportunities against a benchmark.

It’s ultimately about working out whether you are happy that the expected return for an investment is indeed appropriate for the risk you must take.