There's always a degree of risk you take when you make an investment, whether you put your money in a stock, bond or other financial instrument. The investment may perform as expected, called the expected return, or underperform, which means you lose money. A risk premium is the level of risk you place above a certainty of investing in a sure investment with zero risk.
Risk is different for every investor. Volatility is a measurement of risk that basically identifies how an investment moves away from your expected rate of return. The more volatile an investment, the higher the risk associated with it. In actuality, there is nothing wrong with risk as long as you get compensated sufficiently for taking on risk. As the saying goes, "the higher the risk, the higher the reward." In reality, it doesn't actually work that way.
The risk-free rate is the theoretical rate of return on an investment with no risk. In actuality, there is always risk when it comes to investing. However, the closest thing to a risk-free rate is investing in a government security such as U.S. Treasuries. Financial analysts use the interest rate on the three-month U.S. Treasury bill as a proxy for a risk-free rate of return because of the certainty that the U.S. government will not default on its debts.
Calculating Risk Premium for a Bond
The risk premium measures the degree of risk you take on an investment. The risk premium is a rate, which is above the risk-free rate. The higher the risk of the investment, the greater the risk premium above the risk-free rate. To determine the risk premium for a bond, you first need to find out the risk-free rate using a government security such as the U.S. Treasury bill. For example, if the risk-free rate is 4.5 percent and you are considering investing in a corporate bond paying interest at 9.5 percent, the risk premium on that bond is 5 percent. In essence, the corporate bonds must compensate investors because of a higher degree of risk compared to if they were to put their money in U.S. Treasury bills.
Calculating Risk Premium for a Stock
Stocks differ from bonds in that a bond investor knows what to expect from his investment — interest payments and return of his principal. A stock investor has no way of knowing his return. He can only use an expected rate of return as a means to justify putting money into a stock. If his expected rate of return is 20 percent and the risk-free rate is 4.5 percent, the risk premium for the stock is 15.5 percent, or 20 percent minus 4.5 percent.
Expected Rate of Return
There are two ways to calculate the expected rate of return for a stock: the earnings-based approach and the dividend-based approach. The earnings-based approach divides a company's earnings per share by the stock price. For example, if a company's EPS is $3 and its company's stock price is $30, the expected rate of return is 10 percent. The dividend-based approach divides a company's dividend by its stock price and adds a growth rate. For example, if a company pays a dividend of $1.50, has a stock price of $25 and a growth rate of 10 percent, the expected rate of return is 16 percent ($1.50 divided by $25 + 10 percent).