risk premium


Risk premium

The reward for holding the risky market portfolio rather than the risk-free asset. The spread between Treasury and non-Treasury bonds of comparable maturity.

Risk Premium

The return over and above the risk free rate of return that an investor expects in exchange for each additional unit of risk. According to Markowitz portfolio theory, rational investors only accept additional risk if they expect a greater return. One refers to this greater return as the risk premium. See also: Risk capital, Eat well, Sleep well.

risk premium

The extra yield over the risk-free rate owing to various types of risk inherent in a particular investment. For example, any issuer other than the U.S. government usually must pay investors a risk premium in the form of a higher interest rate on bonds to account for the fact that the risk of default is less on U.S. government securities than on securities of other issuers. Also called bond premium risk.

Risk premium.

A risk premium is one way to measure the risk you'd take in buying a specific investment. Some analysts define risk premium as the difference between the current risk-free return -- defined as the yield on a 13-week US Treasury bill -- and the potential total return on the investment you're considering.

Other measures of risk premium, which are applied specifically to stocks, are a stock's beta, or the volatility of that stock in relation to the stock market as a whole, and a stock's alpha, which is based on an evaluation of the stock's intrinsic value.

Similarly, the higher interest rates that bond issuers typically offer on bonds below investment grade may be considered a risk premium, since the higher rate, and potentially greater return, is a way to compensate for the greater risk.

risk premium

the additional return on an INVESTMENT which an investor requires to compensate for the possibility of losing all or part of that investment if future events prove adverse. The size of the risk premium will depend to an extent upon the personality of the investor. Some cautious investors are ‘risk averse’ and require a substantial risk premium to induce them to undertake risky investments. Other less cautious investors are ‘gamblers’ and demand little risk premium. Attitudes to risk also depend upon the size of the potential gains or losses involved. Where a project risks making a loss which is so large as to endanger the future solvency of the investor then investors would tend to adopt a cautious view about the downside risk involved, even when such losses are highly unlikely, and would demand a substantial risk premium. See DECISION TREE, UNCERTAINTY AND RISK, CAPITAL ASSET PRICING MODEL.

risk premium

the additional return on an INVESTMENT that an individual and business manager requires to compensate them for the RISK of losses if the investment fails. Investors in government BONDS, where there is very little risk of the borrower defaulting, would require a more modest return on such an investment than the return they would require on an investment in, say, a small newly established company where there is a significant risk that the company will fail and the investors lose some or all of their investment.

Attitudes to risk are partly dependent on the personality of the investor, some investors being very cautious and ‘risk-adverse’, so requiring a large risk premium to induce them to take the risk. The risk premium demanded by investors is also influenced by the size of the potential gains or losses involved. For example, where an investment project risks making a loss that is so large as to endanger the continued existence of the sponsoring company, then managers would tend to adopt a cautious view about the risks involved.