Formula to Calculate Risk Premium
The risk premium is calculated by subtracting the return on risk-free investment from the return on investment. Risk Premium formula helps to get a rough estimate of expected returns on a relatively risky investment as compared to that earned on a risk-free investment.
- ra = asset or investment return
- rf = risk free return
Types of Risk Premium
Specific forms of premium can also be calculated separately, known as Market Risk Premium formula and Risk Premium formula on a Stock using CAPMUsing CAPMThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.. The former calculation is aimed at calculating the premium on the market, which is generally taken as a market index like the S&P 500 or Dow Jones. This is achieved by subtracting returns on a risk-free investment from a probable return on a similar investment in a specific market index.
Market Risk Premium = Rm – Rf
The risk premium on a stock using CAPM is intended to help understand what kind of additional returns can be had with investment in a specific stock using the Capital Asset Pricing Model (CAPM). The risk premium for a specific investment using CAPM is beta times the difference between the returns on a market investment and the returns on a risk-free investment.
Expected Return = rf + Beta (rm – rf)
Person ABC wants to invest 100,000 US$ for the best returns possible. ABC has the option to invest in risk-free investments like the US treasury bond, which offers a low rate of return of only 3%. On the other hand, ABC is considering an investment in a stock that can give returns up to 18%. To calculate the risk premium example for taking on the extra amount of risk involved with this stock investment, ABC would carry out this mathematical operation:
Risk Premium = ra (100,000 x 18 / 100) – rf (100,000 x 3 / 100) = 18,000 – 3000 = 15,000 US$
Hence, in this case, ABC enjoys a 15,000 US$ risk premium example with this stock investment as compared to the risk-free investment. However, it entirely depends on the performance of the stock, and if the investment outcome turns out to be positive. For this, ABC would need to understand the risk factor involved by studying the fundamentals of the stock at length and assess if this investment is worth it and whether he would be able to realize the risk premium or not.
Equity Risk Premium for US Market
Here, I have considered a 10 year Treasury Rate as the Risk-free rate. Please note that some analyst also takes a 5-year treasury rate as the risk-free rate. Please check with your research analyst before taking a call on this.
source – bankrate.com
Market Risk Premium (RM – RF)
Each country has a different Risk Premium. Equity Risk PremiumEquity Risk PremiumEquity Risk Premium is the expectation of an investor other than the risk-free rate of return. This additional return is over and above the risk free return. primarily denotes the premium expected by the Equity Investor. For the United States, Equity Risk Premium is 6.25%.
source – stern.nyu.edu
- Market premium = Rm – Rf = 6.25%
- Rf = 2.90%
- Expected Return from the Equity Market = Rm = Rf + Market Premium = 2.90 + 6.25% = 9.15%
Use and Relevance
It must be carefully understood that market premium seeks to help assess probable returns on investment as compared to any investment where the risk level is zero, as in the case of US-government issued securities. This additional return on a risk-laden investment is in no way promised or guaranteed in this calculation or by any related factor. Should this investment outcome be negative, the premium calculation would have little relevance to that. It was the risk that an investor agreed to take upon in return for extra returns should the investment have a positive outcome. This difference between anticipated returns and actual returns that might be had on any investment must be understood clearly.
Risk Premium Calculator
You can use the following Risk Premium Calculator
|Risk Premium Formula =||Ra − Rf|
|(0 * (0 / 100)) − (0 * (0 / 100) =||0|
Risk Premium in Excel (with excel template)
Let us now do the same Risk premium example above in Excel. This is very simple. You need to provide the two inputs of investment return and risk-free return.
You can easily calculate this premium in the template provided.
This has been a guide to Risk Premium formula, its uses along with practical examples. Here we also provide you with a Risk premium Calculator with a downloadable excel template.