Risk Premium - Explained
What is a Risk Premium?
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Table of ContentsWhat is a Risk Premium?How Does a Risk Premium Work?
What is a Risk Premium?
The risk premium is the difference between the risk-free rate of return and the rate of return of an individual stock that carries risk. The stocks with a higher amount of risk offer additional returns to compensate for the risk and entice the investors to choose a riskier investment over the safer ones. Larger, established companies offer a low rate, as their chances of defaulting is very low. New companies with uncertain profitability offer a higher rate to convince the investors of investing in their business.
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How Does a Risk Premium Work?
Investors agree to make a risky investment only when they are compensated properly with a risk premium or additional returns above the risk-free rate of return. In the U.S., the government issued three-month Treasury bills are considered to be the safest investments. The rate of return offered on these notes is used as the proxy of the risk-free rate of return. Investors risk losing their money in exchange for the promise of extra return if the business earns a profit. The risk premium is risk compensation just like people working in hazardous jobs get risk compensation for their risky work. This is also called the price of risk. Risk premiums may put an extra burden on the company issuing the debt instrument. A high rate of return may contribute towards the company's default. So, the investors should reconsider the level of a risk premium they demand in order to secure their own return objectives. The companies have to offer risk-premium to the investors in order to secure the funding, but they need to devise the policy with utmost caution and care. It should not put a huge burden on the company's finances, as that may result in a default.