Risk Premium
A risk premium is the additional return that investors require, or expect to receive, for holding a risky asset rather than a risk-free one. It is the compensation for bearing risk, and it reflects the aversion of investors to uncertainty about future returns. Risk premia are observed in the returns on equities, corporate bonds, and other assets, and they vary over time and across assets according to the nature and the magnitude of the risk involved.
The concept
The risk premium is the difference between the expected return on a risky asset and the return on a risk-free asset, such as a government bill. Because investors dislike risk, they require a higher expected return to hold a risky asset, and the premium is the extra return that compensates them. The premium depends on the amount of risk, measured by the volatility of returns, and on the degree of risk aversion of investors.
Risk can be divided into components that can be diversified away and components that cannot. Idiosyncratic risk, specific to an individual asset, can be eliminated by holding a diversified portfolio, and investors are not compensated for bearing it. Systematic risk, which affects the market as a whole and cannot be diversified away, is the risk for which investors are compensated, and the premium on an asset depends on its exposure to systematic risk.
Determinants
The size of the risk premium depends on several factors. The volatility of the asset's returns raises the premium, because greater uncertainty requires greater compensation. The degree of risk aversion of investors matters, since more risk-averse investors demand higher premia. The correlation of the asset's returns with the returns on other assets, and with consumption, also matters, because assets that do poorly when consumption is low are especially risky and command higher premia.
The supply of and demand for risky assets affect the premium. When investors are willing to bear more risk, or when the supply of safe assets is abundant, premia may be compressed, while during periods of stress, when risk aversion rises and liquidity is sought, premia widen sharply. The level of the premium is therefore not fixed but varies with conditions, reflecting changes in risk and in the preferences of investors.
Examples
The equity risk premium is the premium of equities over risk-free assets, and its historical magnitude is a subject of extensive research. The credit risk premium is the premium of corporate bonds over government bonds of the same maturity, and it reflects the risk of default and the compensation for bearing it. The term premium is the premium of long-term bonds over short-term ones, and it reflects the risk of holding long-dated assets.
Premia also appear in other markets. The currency risk premium is the return from holding a currency relative to another, and it reflects differences in risk. The liquidity premium is the compensation for holding an asset that is difficult to sell quickly, relative to one that is liquid. Each premium reflects a specific risk, and the analysis of premia is central to asset pricing and to the allocation of capital.
Applications
Risk premia are used to price assets, to evaluate investments, and to assess the stance of financial conditions. The required return on a project or an investment is the risk-free rate plus a premium that reflects its risk, and this required return is used as the discount rate in valuation. Estimates of the equity risk premium, the credit premium, and other premia are inputs to the valuation of firms, of bonds, and of other assets.
Premia also provide information about the economy and about financial stability. Wide premia may signal elevated risk aversion and concern about the outlook, while compressed premia may signal complacency and excessive risk-taking. Central banks and supervisors monitor premia as indicators of conditions, and the variation of premia over the cycle is central to the analysis of financial stability and of the transmission of monetary policy.
The term structure
Risk premia are central to the term structure of interest rates. The expectations hypothesis states that long-term rates reflect expected future short-term rates, while the term premium is the additional compensation for holding a long-term bond rather than a sequence of short-term bonds. The term premium reflects the risk of interest rate changes and of inflation, and it varies over time and across maturities.
Decomposing long-term rates into expectations and premia allows analysts to interpret movements in yields. A rise in yields may reflect higher expected rates, a higher term premium, or both, and the interpretation has different implications for policy and for the outlook. Estimating the decomposition requires models of the term structure, and the estimates are uncertain, particularly about the level and the variation of the term premium.
Determinants of variation
Risk premia vary with conditions. They are low when investors are confident and when volatility is low, and they rise when uncertainty increases and when investors seek safety. The variation reflects changes in risk aversion, in the supply of risky assets, and in liquidity conditions, and it is a central feature of financial markets.
The variation has implications for the real economy. Wide premia raise the cost of capital for firms and households, reducing investment and consumption, while narrow premia lower it, encouraging risk-taking. The level of premia is therefore a determinant of the cost of finance and of the level of activity, and it is monitored by central banks and by supervisors as an indicator of financial conditions and of the stance of policy.
Measurement
Measuring risk premia requires estimates of expected returns and of the risk-free rate. Expected returns are not observed, and they are inferred from models of asset pricing, from surveys, or from valuation ratios. The resulting measures are model-dependent, and different methods give different estimates, so the level and the variation of the premia are uncertain.
The measurement challenges are greatest for assets that are illiquid or that are traded infrequently, where observed prices may not reflect the returns that investors expect. Iliquidity and other frictions mean that observed prices include compensation for characteristics that are not captured by standard measures. Analysts therefore use a range of methods and interpret the results with caution, and they supplement market data with survey evidence and with model-based estimates.
Financial stability
Risk premia are important for financial stability. Compressed premia may encourage borrowing and risk-taking, as investors search for yield, and they can lead to the build-up of vulnerabilities. The unwinding of compressed premia, when conditions change, can be abrupt and disruptive, as positions are reversed and prices adjust, potentially triggering a sharper deterioration in financial conditions.
Supervisors and central banks monitor premia as indicators of the build-up of risk and of the potential for a disorderly adjustment. The analysis of premia is therefore part of the broader assessment of financial conditions and of the risks to stability, and it informs the design of macroprudential policy that aims to contain the build-up of vulnerabilities and to strengthen the resilience of the financial system.