how a risk premium works
think of risk premium as a form of hazard pay for your investments an employee assigned dangerous work expects to receive hazard pay in compensation for the risks they undertake it s similar with risky investments a risky investment must provide the potential for larger returns to compensate an investor for the risk of losing some or all of their capital this compensation comes in the form of a risk premium which is the additional returns above what investors can earn risk free from investments such as a u s government security the premium rewards investors for the prospect of losing their money in a failing business and it isn t actually earned unless the business succeeds a risk premium can be construed as a true earnings reward because risky investments are inherently more profitable should they succeed investments in well penetrated markets and which tend to have predictable outcomes are not likely to change the world on the other hand paradigm shifting breakthroughs are more likely to come from novel and risky initiatives it s these types of investments that can potentially offer superior returns which a business owner may then use to reward investors this one underlying incentive is why some investors seek riskier investments knowing they can reap potentially bigger payoffs premium costa risk premium can be costly for borrowers especially those with doubtful prospects these borrowers must pay investors a higher risk premium in the form of higher interest rates however by taking on a greater financial burden they could be jeopardizing their very chances for success thus increasing the potential for default with this in mind it is in the best interest of investors to consider how much risk premium they demand otherwise they could find themselves fighting over debt collections in the event of a default in many debt laden bankruptcies investors recoup just a few cents on the dollar on their investment despite the initial promises of a high risk premium while economists acknowledge an equity premium exists in the market they are equally confused as to why it exists this is known as the equity premium puzzle the equity risk premiumthe equity risk premium erp refers to the excess return that investing in the stock market provides over a risk free rate this excess return compensates investors for taking on the relatively higher risk of buying stocks the size of the premium varies depending on the level of risk in a particular portfolio and also changes over time as market risk fluctuates as a rule high risk investments are compensated with a higher premium most economists agree the concept of an equity risk premium is valid over the long term markets compensate investors more for taking on the greater risk of investing in stocks 1the equity risk premium can be computed in several ways but is often estimated using the capital asset pricing model capm capm cost of equity r f r m r f where r f risk free rate of return beta coefficient for the stock market r m r f excess return expected from the market begin aligned text capm cost of equity r f beta r m r f textbf where r f text risk free rate of return beta text beta coefficient for the stock market r m r f text excess return expected from the market end aligned capm cost of equity rf rm rf where rf risk free rate of return beta coefficient for the stock marketrm rf excess return expected from the market the cost of equity is effectively the equity risk premium rf is the risk free rate of return and rm rf is the excess return of the market multiplied by the stock market s beta coefficient from 1928 to 2022 the u s erp averaged 5 06 compared with 4 6 for the 1871 1925 period and 2 9 for the earlier 1802 1870 period 23 from 1926 to 2002 the equity risk premium was particularly high at 8 4 which puzzled economists 45 from 2011 through 2022 the average market risk premium in the u s was 5 5 67at the beginning of may 2023 the erp stood at 4 77 according to aswath damodaran a professor at the stern school of business at new york university that is slightly less than average and a sharp drop from the 5 94 registered at the start of 2023 8lower erps generally make investing in stocks less compelling whereas higher erps imply higher potential rewards the year 2022 was a volatile one for stock markets and the erp subsequently moved quite a bit according to damodaran it started 2022 at 4 24 and began 2023 at 5 94 perhaps implying that the market was viewed as undervalued after a sharp sell off 9the drop in erp since the start of 2023 can be attributed to several factors including a rise in equity valuations and a series of interest rate hikes from the federal reserve boosting returns on safer fixed income investments the average u s equity risk premium in 2022 6