Define a Market Risk Premium
Risk premium is the added compensation an investor receives for placing his money at risk of loss. The greater the risk of an investment, the greater the risk premium the investor receives. It is the equivalent of hazardous duty pay.
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Investor Motivation
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Investors are motivated by many factors. Investors are motivated to invest by a variety of factors. Some investors are motivated primarily by the safety of the investment, others by the return on the investment. The risk premium is the "great equalizer" that should "theoretically" make investors indifferent to the risk since the investment has already built in compensation for the risk.
Risk Preference
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Investors who do not like risk shy away from risky investments regardless of the risk premium. There is a cutoff point for all investments beyond which even the most risk prone of investors will not respond. Many security issues fail to meet the expectations of their issuers simply because they are just too risky. This applies to new companies without a track record of sales and earning to warrant investor confidence.
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Risk Premium in Debt Finance
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The lower the risk, the lower the yield. In corporate debt finance, the risk premium is the expected rate of return above a risk-free interest rate. Investors typically use the T-bill rate as the benchmark for a risk-free investment since T-bills are backed by the full faith and credit of the U.S. government. The difference between the T-bill rate and the corporate bond rate is the risk premium, or what is commonly known as the "credit spread." It is the measure of the degree of risk relative to a risk-free investment. It is the difference in risk between a sure thing (the T-bill) and an uncertain thing (the corporate bond).
High-value, low-risk corporate bonds from a company with a long-standing history of profitability will have a lower credit spread relative to the T-bill than a junk bond from XYZ Corporation that has been in operation for three years with a checkered history of profitability.
Risk Premium in Equity Finance
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Net present value is used to determine risk in equity financing. In equity finance, the risk premium calculation is slightly more complicated. It is the total return from both dividends and appreciation of a stock that is calculated out to a defined time in the future--say 10 years. The accumulated returns are then discounted back to the present using the discount rate. The discount rate includes a combination of the time-value of money (a dollar today is worth more than a dollar next year) and the risk premium rate (the uncertainty of the reliability of the calculated returns), to arrive at the net present value for the stock. Investors use the net present value calculation to assess the risk of purchasing one particular stock versus another.
Risk Premium in Consumer Markets
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The risk premium in consumer markets is the difference (the spread) between the prime rate and the interest rate a consumer would be charged for a consumer loan product. The prime rate is the interest rate banks charge their best, most credit-worthy customers. Customers with less than sterling credit are charged rates higher than the prime rate. When a customer pays a very high interest rate for a consumer loan product, it is indicative of the fact the customer has a checkered credit history or an exceedingly high loan-to-debt ratio, thereby making any loan riskier to the lender.
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References
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