Risk Premium - What Are They?
Is it possible for the risk premium to be negative before the investment is undertaken? Can the risk premium be negative after?
A risk premium is an amount an investor is expected to receive for risking the loss of their money for the investment. Usually, investors who make risky investments are rewarded with greater returns.
The point of risk premium is so that an investor can achieve a higher rate of return on a given investment because they are accepting more risk.
In order to calculate the risk premium, the investor first has to calculate the estimated return, as well as the risk-free rate of return. This is one way that investors are able to assess the risk of an investment.
A negative risk premium happens when the estimated rate of return on a given investment is less than the risk-free rate. Because investors are tolerating the extra risk, they expect to be properly compensated, as the whole point of a risk premium is to yield a higher return.
One example would be, if an investor calculates the estimated return on investment to be 6 per cent and the risk-free rate is at 2 per cent, this means the risk premium is 4 per cent. The risk premium amount of 4 per cent is what the investor would hope to be compensated for making a risky investment.
Therefore, the riskier the investment, the higher the return the investor expects.
The concept of risk premium is used by investors in a number of ways. More specifically, it is applied to companies and equities to measure how much the investor will be compensated for taking on the extra risk. Risk premium can also be used to measure an industry valuation, an example of this would be when a smaller company has a higher premium than a bigger, more established organisation.
