Risk Premium. MarketCheese

Risk Premium — is an extra charge for the investment in more risky assets. Such a premium is paid for the investment in high-yielding assets like cryptocurrency, futures, options, or treasures. The higher the expected risk premium, the more profitable the investment can be. A small risk premium means that the potential for future returns isn’t very high.

What Defines Risk Premium

The risk premium shows how much the return on a security or portfolio exceeds the return on investment in zero-risk assets. The risk premium isn't an integral indicator, since it depends on the current quotations of assets, including risk-free ones. The risk premium can be computed only based on historical data since changes in instrument prices aren't predictable. All forecasts are probabilistic.

The usage of the risk premium is based on an important underlying hypothesis of investment analysis: all investors prefer to avoid risk and are willing to accept a higher level of risk only if it promises a higher level of return. The majority of investors do this and try to protect their investment portfolios.

The risk premium is defined by several factors related to the various circumstances. They are related both to the financial system and the economic situation in the country.

Factors defining the risk premium:

Inflation. High inflation destroys the revenues and values of assets.
Exchange rate. The value of an asset depends on the exchange rate of the monetary unit to which it is pegged. If the monetary unit gets cheaper, the value of assets falls.
Political situation. The equity risk is related to the political climate. When the political situation is unstable, the quotations decrease.
Changes in the key rate. When the key rate is raised by the Central Bank, assets lose value and vice versa, since it is easier for companies to raise borrowed funds and develop their business.
Business risk. This risk is related to the reputation of the issuing company. The assets of stable and reliable companies are less risky.
Credit risk. If the company is over-leveraged, there may be a threat of financial instability, which will lead to a fall in the share price.
Industry risk. The state of industry influences the corresponding asset.

An ideal option for an investor is to receive income without the risk of loss. Unfortunately, this is impossible. Even bank deposits or government bonds can’t guarantee a risk-free return. These assets are very close to risk-free, that’s why individuals include them in their portfolios as protective ones. But their profitability is low, and in some cases doesn’t even cover inflation.

The assets related to the state are considered the most safe, as the government protects them. However, the investor should consider the state of the economy and follow the economic and political trends. In the time of crises and economic turbulence the state assets lose their profitability.

Calculation of Risk Premium

Investors utilize various methods to compute the risk premium. If the investors can calculate the risk premium, they can know the amount of return. They need to decide: invest in this instrument or give preference to other assets. Regardless of the method used for the calculation of risk premium, it is important to consider that none of them can guarantee the exact result and 100% predict the outcome of the transaction.

Another popular method is the Fama-French three-factor model. The Fama-French three-factor model adds two new values to CAPM in addition to the return of the market index: SMB — Small Minus Big and HML — High Minus Low. Arbitrage Pricing Theory is based on the hypothesis that there can be not one parameter, as in CAPM, and not three, as in the Fama-French model, but an arbitrary number.

In most cases, the investors use the portfolio theory of Markowitz. Harry Markowitz is an American economist who has received the Nobel Prize for this theory. The main task of the investor, according to Markowitz, is to be able to select assets with minimal risk and maximum profitability. This theory was based on his article in a financial magazine. Later, Markowitz has written a monograph about this theory.

Here is the formula of risk premium:

Markowitz divides portfolio formation into two stages. The first stage is the analysis of historical data. Here, the future profitability and risk for each stock are determined based on the existing quotes of securities. The second stage is the formation of the portfolio. An investor should select the securities with the best yield and lower risk. Then the portfolio is optimized. Investor leaves the asset with the best return and with minimal risk. The future return is an unknown value. There is only the probability that a random variable will take one or another value. The most probable value of a random variable is called its mathematical expectation. Markowitz identified it as future income. Markowitz defined risk as the spread of stock prices. The higher the spread of quotes, the bigger the investor's risk.