Introduction
If you are investing in stocks or mutual funds, you should know all the factors affecting the trading. It is pertinent to learn about the company holding the shares and whether it is financially stable or not. Many models and processes are there for you to carry out successful trading. Similarly, the traders must follow several principles to increase the profit potential. Even when you seem to have losses in trading, it can be compensated for if the further movements are wise.
Knowing the risk premium in detail is one such factor that lets you know which shares to invest in for higher returns. Risk premium will help traders to invest in assets with risks as the same will bring lucrative gains. This write-up will help you gain in-depth knowledge about risk premiums. Let’s dive deep into it.
Understanding what is a risk premium
When you invest in a particular stock or bond, there might be losses due to the declining market value. The investment return will provide you with the lost sum in such a scenario. This procedure is known as risk premium, which will always be over the value of the risk-free rate. If you understand what risk premium is, you will be able to know all the concepts of trading quickly. Usually, beginner-level traders go to invest in assets that have no risks.
After learning the procedures and techniques of trading, to some extent, you can start to invest in riskier assets. Only when you invest in such kinds of assets or shares can you expect a higher rate of return on the investment. To know the risk premium, the investor must first evaluate the expected return and risk-free return rate. If the rate of return falls below the risk-free rate, the risk premium will become negative. Basic knowledge about all this will help the investors to act wisely by investing in a guaranteed source.
Relation between Risk Premium and CAPM
The investor can get the benefit by knowing the compensation for the loss and the return on investment. A model called the Capital Asset Pricing Model is used to find an estimated return, and it uses the risk premium to calculate the asset’s return value and the risk-free rate.
This CAPM needs a formula that uses the Beta value of the stock. On the other hand, you can calculate the risk premium by knowing the risk-free rate and excess return for the investment. For example, the estimated return will equal the risk premium if you invest in a risk-free asset. Similarly, when you invest in a risky trade with an 8 percent estimated return and a risk-free rate of 3 percent, the risk premium will sum up to 5 percent. This risk premium will make up for the loss. It finds a significant application in the CAPM formula.
Example of risk premium
There are various citations for explaining the meaning of risk premium. It would be best if you calculate the risk premium by subtracting the risk-free rate from the expected rate of return, which will be the recompensation.
Let us assume a player in a game show is offered two options. He can opt for picking one of the two boxes with 10000 bucks, and the other box has no money. The other choice is that he can directly get 5000 bucks. In this example, if the player wants to win 10000 bucks, he must make a riskier decision as the probability of success is 50%. On the other hand, if the player gets 5000 bucks and leaves straight away, it is a risk-free option. The same criteria are applied to the concept of risk premium. To make the players choose the riskier option, the organizer may offer 3000 bucks if, unfortunately, the gamer opens the box having no prize. The 3000 bucks offered is known as the assured risk premium in the case of trading.
Market risk premium and its working
The market risk premium works based on three components. They are:
- actual market risk premium
- recorded market risk premium
- estimated market risk premium.
If you are investing, you will expect a higher amount than the investment. This expected gain is the actual market risk premium. The historical risk premium already recorded for the previous trading for the same instrument is known as the recorded market risk premium. The estimated market risk premium is the rate of return you expect more than the standard return.
Something called the S & P 500 is kept as the standard for deriving the historical market risk premium. The standard risk-free rate can be estimated by keeping bonds with no risks or lower risks, and a government bond can be used for this purpose. By applying the risk premium formula, you can be sure that at least a small return will be assured in case of a loss.
Final thoughts
The risk premium can help only to a certain extent. If there is an unexpected fluctuation in the market value, you will not gain the expected risk premium. Therefore, only after knowing the basics of trading and gaining experience can you be sure about investing in risky assets.
This article sums up the usage of risk premium, the example for understanding the risk premium better, and the working of risk premium. When you get into trading, you should apply the risk premium formula with other investment techniques. By just knowing the concept of risk premium, you will not be able to gain lucrative profits.
References
- https://www.investopedia.com/terms/r/riskpremium.asp
- https://www.bankrate.com/glossary/r/risk-premium/
- https://strategiccfo.com/articles/investment-shareholders/risk-premium/
- https://corporatefinanceinstitute.com/resources/knowledge/finance/market-risk-premium/
- https://en.wikipedia.org/wiki/Risk_premium
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