# How To Calculate Risk Premium

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Investors love the rewards that come with finding a good investment, but they hate the risk they must absorb to find that investment. The tolerance for risk is a subjective thing, but it can be given a number. That number is called the risk premium, and it indicates the kind of “wiggle room” an investor is comfortable with when it comes to an investment. Risk premium sounds like a complicated term, but it is actually a very simple indicator any investor can use to determine their comfort level with an investment.

Expected Return

The expected return on an investment is an estimate based on past performance. In the securities world, any company or person who issues an investment is very careful to make it clear that past performance is not any promise of future returns. That is the risk that investors assume. For example, an investment might be rated to have an expected return of 10 percent per year, but that does not mean that you will make 10 percent. You could make 10 percent, or 20 percent or zero percent. You could make a big profit, or you could lose everything.

Baseline Returns

Most securities formulas have what is referred to as a baseline return. This is a real number that has remained steady and stable despite changes in the markets. For example, United States treasury bonds tend to have a very stable rate of return because they are backed by the U.S. government. When investors want a baseline return number, they will often use the expected return for U.S. treasury bonds. Since we are talking general numbers, it is possible to use the expected return of a bond to calculate the potential return on a stock or other investment.

Let’s say that you choose the U.S. treasury bond as your baseline return and it gives an expected return of five percent. Now let’s say you are looking at an investment that has an expected return of 10 percent, and it is not a treasury bond. Your formula for risk premium would be:

Risk Premium = Expected Return – Baseline Return

In this case, the calculation would be:

10 percent – 5 percent = 5 percent