What is Risk Premium?

Published by Thomas Herold in Economics, Investments

'Risk Premium' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

A risk premium turns out to be the surplus return over the risk free rate of return which investments are anticipated to provide. Any asset offers such a premium as a means of rewarding those investors who are willing to take on the additional risk as opposed to an asset which is risk free. Examples of this abound.

Excellent credit rated companies’ corporate bonds do not entail much, if any, risk of default. This is because such businesses have a proven track record of paying their debts in a timely fashion and significant profits as well as cash flow. It is ultimately why these types of bonds deliver a substantially lower yield or interest payment than do bonds from companies which are less well established and have uncertain financials leading to a greater risk of default.

Risk premium could be regarded as a form of hazard pay for investment portfolios. This is much like those employees who perform jobs deemed to be dangerous and obtain a hazard pay in compensation for the risks in which they engage on the job. Similarly, risky types of investments have to offer investors the possibility of greater returns in order to justify the higher risks which the investment involves.

Investors only undertake such perilous investments because they anticipate receiving appropriate compensation for the level of risk they assume. They receive this in the form of a risk premium, or higher returns above the rates of return that such low risk investments as U.S. Treasury issued securities provide. Another way of putting it is that because investors might lose money thanks to the insecurity of a given investment, they receive higher returns as their reward should the investment work out successfully. The possibility of obtaining such a premium does not guarantee that investors will actually receive it. This is because the borrower could go bankrupt or default if the outcome of the investment is not at least partially successful.

Such a risk premium may be a gratifying recompense because investments which are riskier are naturally more profitable if and when they turn out to be successful. Those investments which possess predictable and sure outcomes will not evolve into financial breakthroughs as they are already successfully performing in markets that are well developed. This is why risky and creative investment and business initiatives are the ones which could possibly provide returns that are better than average. The borrowing entity rewards its investors for taking on their risk in backing the idea or business effort. Because of this fact, some investors have been willing to seek out and fund riskier investments with the hope of obtaining significantly greater payouts.

The truth is that such a risk premium is expensive for the companies who borrow. This is more the case if their various investments or ideas will not necessarily pan out as the most successful or lucrative ones. The greater the premium these companies promise their investors as compensation for the entailed risk, the higher a financial burden they experience. Such burdens can actually be detrimental to the success of their endeavors and lead to greater chance of a final default.

This is why investors’ best interest lies in tempering the amount of risk premium they insist on from their investments. The alternative is that they will have to line up and battle against other debt collectors if the company they backed financially defaults in the end. The sad truth is that with many bankruptcies heavily mired in debt, most investors recover only a matter of cents on their dollars, regardless of how high the risk premium offered initially proved to be.

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The term 'Risk Premium' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.