What is Risk Premium

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Risk premium = ra – rf

ra = ROI or sometime assets
rf = risk-free return

Risk premium formula is used to determine the return with a risk involving investment. Risk premium formula is sometime also simply referred as risk premium. Basically, risk premium is the amount which an investor would like to earn after taking a specific level of risk in an investment.

To get a risk-free rate a common practice is to use ‘T-Bill’ (US Treasury bill) for calculation purpose. On the other side theoretically, a risk free rate is that which involves no risk at all.

Risk premium of the market

To calculate risk premium of market risk free rate is deducted from average return on the market. In this concept ‘the market’ term in respect to stocks indicates towards the entire stocks index i.e. S&P 500. The market risk premium formula can be show as;

Market Risk Premium = Rm – Rf

Market risk is also referred as systematic risk. While on the other side, unsystematic risk indicates towards the risk linked with an investment but not related to market. Therefore diversification in investment portfolios helps to minimize the risks but to some extent only. The concept of diversification comes in when investors discovered the systematic and unsystematic risks and their relationship with returns.

Calculating Stock Risk Premium using CAPM

The risk premium of any investment can also be determined by using capital asset pricing model. In CAPM calculates the return by adding risk free return in beta times the difference between the market return and risk free return of investment.

CAPM Return = rf + β(rm – rf)

As stated earlier, that the difference in risk free investment return and return on market is known as market risk premium. So, the above formula can be restated as;

CAPM Return = rf + β(Market Risk)

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