Risk Premium Definition
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.
A Little More on What is a Risk Premium
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 finance, as that may result in a default.
References for Risk Premium
Academic Research on Risk Premium
The equity risk premium a solution, Rietz, T. A. (1988). Journal of monetary Economics, 22(1), 117-131. This study re-specifies the Arrow-Debreau asset pricing model and captures the effects of potential market crashes although they are unlikely. The study maintains the attractive features of the model, and this enables it to describe high equity risk premium as well as low risk-free returns. As long as the crashes are plausibly severe and not improbable, the study performs the description with a reasonable extent of time preference and risk aversion.
The equity premium puzzle and the risk-free rate puzzle, Weil, P. (1989). Journal of Monetary Economics, 24(3), 401-421. This article investigates the implications for general equilibrium asset pricing of a class of Kreps-Porteus unexpected utility preferences symbolized by a continuous intertemporal elasticity of substitution and a constant coefficient of relative risk aversion. However, a risk-free puzzle emerges that attempts to determine why the risk-free rate is very low if agents are so opposed to intertemporal substitution.
Post-earnings-announcement drift: delayed price response or risk premium?, Bernard, V. L., & Thomas, J. K. (1989). Journal of Accounting research, 1-36. This study differentiates between competing explanations of post-earnings-announcement drift. Some of the results of the survey are not easy to reconcile with plausible explanations based on incomplete risk adjustment. However, they are consistent with a delayed response to the information. Later in the study, a discussion of the evidence as well as the formulated conclusions are presented.
The forward discount anomaly and the risk premium: A survey of recent evidence, Engel, C. (1996). Journal of empirical finance, 3(2), 123-192. This paper explores the advances in forward exchange rate since Hodrick’s survey was published. It presents findings which indicate that the change in the future exchange rate is generally negatively related to the forward discount. It covers issues which include the relationship of uncovered interest parity to real interest parity and also the effects of uncovered interest parity for cointegration of various quantities.
Forward discount bias: Is it an exchange risk premium?, Froot, K. A., & Frankel, J. A. (1989). The Quarterly Journal of Economics, 104(1), 139-161. This research uses survey data on exchange rate expectations to discuss the common finding that the forward discount is a biased predictor of future exchange rate changes. It separates the bias into parts attributable to the risk premium and expectational errors. The research also refutes the claim that the risk premium is more variable than expected depreciation.
Conditional variance and the risk premium in the foreign exchange market, Domowitz, I., & Hakkio, C. S. (1985). Journal of international Economics, 19(1-2), 47-66. This paper examines the presence of a risk premium in the foreign exchange market based on the conditional variance of several market forecast errors. The errors are presumed to adhere to the ARCH process introduced by Engle. The paper also discusses the estimation and diagnostic testing of the model and provides the results for currencies of various countries.
Assessing alternative proxies for the expected risk premium, Botosan, C. A., & Plumlee, M. A. (2005). The accounting review, 80(1), 21-53. This research evaluates five methods of deducing firm-specific ‘r’ that operate differently from each other. The basis of this assessment is the degree to which the estimates are associated with form risk in a stable and meaningful way. The research identifies that two estimates are consistently and predictably related to risk while the others are not.
Delta-hedged gains and the negative market volatility risk premium, Bakshi, G., & Kapadia, N. (2003). The Review of Financial Studies, 16(2), 527-566. This article investigates if the volatility risk premium is negative by examining the statistical properties of delta-hedged option portfolios. It also demonstrates a correspondence existing between the sign and magnitude of the volatility risk premium and the mean delta-hedged portfolio returns. The evidence in this article supports a negative market volatility risk premium.
Global banking glut and loan risk premium, Shin, H. S. (2012). IMF Economic Review, 60(2), 155-192. This paper explains that US dollar-denominated assets of banks outside the US are equivalent to the total assets of the US commercial bank sector although the netting masks the large gross cross-border positions out of the gross assets and liabilities. The paper brings together evidence from the analysis of a global flow of funds and creates a theoretical model that links global banks and US financial conditions.
What risk premium is “normal”?, Arnott, R. D., & Bernstein, P. L. (2002). Financial Analysts Journal, 58(2), 64-85. This article has a purpose of estimating the objective of the forward-looking US equity risk premium relative to bonds through history. The evaluation of this topic is carried out several careful steps. The paper also demonstrates that the long-term forward-looking risk premium is nowhere near the level of the past.
Global evidence on the equity risk premium, Dimson, E., Marsh, P., & Staunton, M. (2003). Journal of Applied Corporate Finance, 15(4), 27-38. This paper extends the evidence on risk premium which has been over relatively brief intervals. The evidence is extended by examining equity, bond, and also bill returns in 16 countries over 103 years. The paper shows that equity risk premium has usually been lower and that even this lower figure for the historical risk premium is an overestimate of the possible future risk premium.