Formula to Calculate Risk Premium

The risk premium is calculated by subtracting the return on risk-free investment from the return on investment. The Risk Premium formula helps get a rough estimate of expected returns on a relatively risky investment compared to that earned on a risk-free investment.

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  • ra  = asset or investment returnrf  = risk free return

Types of Risk Premium

Specific premium forms can also be calculated separately, known as the 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.read more. The former calculation aims to calculate the premium on the market, which is generally taken as a market index like the S&P 500 or Dow Jones. It is achieved by subtracting returns on a risk-free investment from a probable return on a similar investment in a specific market indexMarket IndexA market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by listing the historical and real-time trends in different market segments. read more.

Market Risk Premium = Rm – Rf

The risk premium on a stock using CAPM is intended to help understand what other 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 a risk-free investment.

Expected Return = rf + Beta (rm – rf)

Example

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 compared to the risk-free investment. However, it entirely depends on the stock’s performance 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 ten-year Treasury Rate as the Risk-free rate. Some analysts also take 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

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.read more 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 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. The risk that an investor agreed to take upon in return for extra returns should the investment have a positive outcome. The difference between anticipated and actual returns on any investment must be understood clearly.

Risk Premium Calculator

You can use the following Risk Premium Calculator

Risk Premium in Excel (with excel template)

Let us now do the same Risk premium example above in Excel. It 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 the Risk Premium formula, its uses along with practical examples. Here we also provide you with a Risk premium Calculator with a downloadable excel template.

  • Market Risk Premium FormulaMarket Risk Premium FormulaMarket risk premium refers to the extra return expected by an investor for holding a risky market portfolio instead of risk-free assets. Market risk premium = expected rate of return – risk free rate of returnread moreWhat is the Risk-Free Rate of Return?What Is The Risk-Free Rate Of Return?A risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read moreExpected Return FormulaExpected Return FormulaThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability.
  • read moreRisk-Adjusted ReturnInternal Growth Rate FormulaInternal Growth Rate FormulaInternal Growth Rate is calculated by multiplying ROA of the company with the retention ratio of the company. The equation is as follows: IGR = ROAr/(1-ROAr).read more