Risk Premium

Key takeaways
* A risk premium is the additional return investors require above a risk‑free rate to compensate for taking on extra risk.
* Riskier assets (e.g., equities, lower‑rated bonds) generally offer higher expected premiums.
* The equity risk premium (ERP) measures the extra return from stocks over a risk‑free investment and is often estimated with the CAPM framework.
* Historical U.S. ERP averages around 5% over long periods, but it fluctuates with market conditions.

What is a risk premium?
A risk premium is the extra return expected from an investment above the risk‑free rate (such as a U.S. Treasury). It compensates investors for the possibility of loss, much like hazard pay compensates workers for dangerous jobs. The premium is only realized if the investment performs; it represents the reward demanded for bearing uncertainty.

Equity risk premium (ERP)
The equity risk premium is the excess return investors expect from holding stocks instead of a risk‑free asset. Size varies by market conditions, portfolio composition, and investor expectations. Higher perceived market risk raises the ERP, making stocks more attractive only if expected returns justify that risk.

Estimating ERP with CAPM
A common approach uses the Capital Asset Pricing Model (CAPM):

Cost of equity = R_f + β × (R_m − R_f)

where:
* R_f = risk‑free rate
* β = asset or portfolio beta (sensitivity to market)
* R_m − R_f = market excess return (the ERP)

The ERP portion is (R_m − R_f); multiplying by β scales the market premium to the specific asset.

Example
If a stock’s expected return is 8% and a risk‑free alternative yields 3%, the stock’s risk premium is 5% (8% − 3%).

Historical context and recent trends
* Long‑run U.S. ERP averages near 5% (e.g., roughly 5.06% for 1928–2022).
* Shorter windows can show substantial variation: multi‑decade periods and market episodes produce higher or lower averages.
* ERP estimates change as valuations and interest‑rate expectations shift; for example, academic estimates and market‑implied ERPs have moved from under 5% to above 5% at different points in recent years.

Impact on borrowers and lenders
Borrowers with uncertain prospects face higher interest costs because lenders demand larger risk premiums to offset default risk. In distressed situations, expected high risk premiums may not materialize if creditors recover only a fraction of principal in bankruptcy.

The equity premium puzzle
Economists accept that stocks have historically earned a premium over risk‑free assets, but debate remains over why this premium is as large as observed — a conundrum known as the equity premium puzzle.

How to calculate a risk premium
Risk premium = Expected return of the risky asset − Risk‑free rate

Use consistent expected returns and a suitable risk‑free proxy when applying this formula.

Bottom line
A risk premium is the market’s price for uncertainty: it motivates investors to accept the chance of loss by offering higher expected returns. ERPs are useful for valuation, portfolio decisions, and pricing capital, but they vary over time and should be interpreted alongside risk tolerance, investment horizon, and market conditions.