Risk Premium Formula: Calculator (with Excel Template)

Calculator in Excel and formula in PDF to allow you to work out risk premium.

by Dheeraj Vaidya CFA FRM
Co-founder & CEO @ eduCBA & founder of WallStreetMojoFollow 105

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Description
A risk premium is the name given to the return in excess of the risk-free rate of return that an investment will be expected to make; the risk premium of an asset is a type of compensation for investors who agree to the extra risk, in contrast with that of a risk-free asset, in an investment. e.g. Established, high-earning corporations that issue bonds have little risk of default. So, these bonds pay an interested rate that is lower than that of bonds that are issued by companies that are less established, have a profitability that is more incertain, and have a higher default risk.

Risk premium could be viewed as a form of hazard pay for the investments you make. Similarly to the way employees in high-risk jobs receive compensation for the risks they pay in the form of 'hazard pay,' risky investments offer the investor potential for bigger returns to warrant the risk level of the investment.

Based on the amount of risk they undertake, investors expect to be sufficiently compensated in the form of a risk premium or in the form of additional returns that are above the rate of return on an investment that is risk-free e.g. U.S. government-issued securities. Basically, investors take the risk of losing their money due to the uncertainty of borrower failure in exchange for gaining extra returns as a reward if the investment is successful i.e. the investment becomes profitable. Therefore, the prospect of potentially earning a risk premium doesn't necessarily mean that investors can get it because it's likely that the borrower may default an investment outcome that is successful.

This Best Practice includes
1 Risk Premium Calculator in Excel, 1 PDF Containing Formula