A risk premium is the additional return that investors expect, or demand, for holding an asset whose payoff is uncertain rather than a safe asset whose payoff is known. It is usually expressed as the asset's expected return minus the risk-free rate, the yield on short-term government debt such as Treasury bills. The premium compensates investors for the chance of losses, delays or a lower payout than promised, and it is the main reason riskier investments are expected, though not guaranteed, to earn more over time.
Risk premiums exist because most investors show risk aversion: given two investments with the same average return, they prefer the less uncertain one. Different premiums attach to different kinds of risk: the equity premium on shares, the credit premium on corporate debt, the term premium on long bonds, and country and liquidity premiums. Together they set the discount rates used in valuation and the price of borrowing for companies and governments.
Imagine two jobs paying the same wage. One is an office job; the other involves working on a high-rise roof. Few people would take the roof job unless it paid more. The extra pay that persuades someone to accept the danger is a premium for risk.
Money works the same way. A government that almost certainly will repay can borrow cheaply. A young company, or a country with a shaky record, has to promise lenders more to persuade them to take the chance. That extra promised return is the risk premium.
How it is calculated
The basic definition is:
- is the expected return on the risky asset.
- is the risk-free rate over the same period.
Worked example: if a five-year corporate bond yields 6.2% and a five-year government bond yields 4.5%, the bond's yield premium, or credit spread, is 1.7 percentage points, or 170 basis points. For shares, the premium cannot be read off a price; it must be estimated. In the Capital Asset Pricing Model (CAPM), a stock's premium equals its beta times the premium on the market as a whole: with a market premium of 5% and a beta of 1.2, the stock's premium is 6%.
- Equity risk premium. The extra return expected from stocks over safe assets. It can be estimated from history, from surveys of investors, or by working backwards from current prices with a dividend discount model. Long-run historical estimates for many countries fall roughly in the range of 3 to 6 percentage points a year, depending on the period, country and method.
- Credit or default premium. Paid by borrowers with a chance of default. It rises as the credit rating falls, from investment-grade bonds to a high-yield bond.
- Term premium. The extra yield for lending long rather than rolling over short loans, compensating for interest rate risk and inflation uncertainty; see term premium. It affects the shape of the yield curve.
- Country risk premium. The extra yield on assets in countries with higher political, currency or default risk, typical of many emerging markets and linked to sovereign risk.
- Liquidity premium. Extra return for holding an illiquid asset that may be hard to sell quickly, such as private loans or property.
Premiums are not fixed. They tend to shrink in calm, confident markets, when investors chase returns, and widen sharply in crises, when they rush to safe assets. During the 2008 financial crisis and the March 2020 market turmoil, corporate credit spreads jumped within weeks. Central bank actions also matter: large-scale bond buying under quantitative easing was intended partly to compress term premiums and lower long-term borrowing costs. The Federal Reserve Bank of New York publishes a widely used model-based estimate of the US Treasury term premium, which was negative for long stretches of the late 2010s and early 2020s before turning positive again.
Puzzles and criticisms
In 1985 Rajnish Mehra and Edward Prescott pointed out that the historical US equity premium was far larger than standard economic models could explain with reasonable levels of risk aversion. This "equity premium puzzle" has prompted explanations ranging from rare-disaster risk and habit formation to loss aversion and survivorship bias in the data, since the US market was one of history's winners. Critics also warn that a premium is an expectation, not a promise: investors can wait many years without receiving it, and a measured premium may simply reflect the period chosen.