How to Calculate Risk Premium

Many investors realize to achieve their financial goals a certain amount of risk is required. It is important to understand the relationship between risk and reward in order to make informed choices of your investments and create your own philosophy around risk. Risk premium is defined as the difference between the rate of return on government securities and common stock.

Instructions

1. Create a list of the investments that you are interested in. Divide them into two categories; common stocks and treasury securities. Common stocks are issued by publicly traded company and are available for purchase on the stock market. Treasury securities are issued by governments.

2. Take the common stocks and review their historical performance over a specific time period. Specifically, look for the average return on equities. This percentage value is part of every companies report to investors.

3. Compare the average return for treasury bills or securities for the same time period. This value is available in any bank or on the treasury board website.

4. Calculate the risk premium by subtracting the average return for treasury bills from the average return for common stocks. This value is the risk premium. This is the standard arithmetic calculation. This method is a good, quick way to calculate the premium, but it is not the most accurate method.

5. Use the Geometric Average to calculate the exact risk premium. This is found by taking the final value, dividing it by the initial value. Multiply this figure by 1/n, where n is the number of periods in the average. Take this answer and subtract it from 1. The answer is the risk premium percentage.

6. Select the appropriate calculation method based on the intended use of the information. If you assume the future will follow the same pattern as the past, the arithmetic calculation is the best one to use. For a longer time period, where the impact of past performance on the future cannot be measured, the Geometric Average method is more useful.