Glossary
Risk premium
The extra return investors demand for holding a risky asset instead of a risk-free one, such as the equity risk premium over Treasuries.
On this page
A risk premium is the additional return investors expect for taking on risk, measured as the gap between a risky asset's expected return and the Risk-free rate. It is the reward for accepting uncertainty: the chance of losses, volatility or a borrower's default. Without a premium, no rational investor would choose a stock or a corporate bond over a Treasury bill.
How it works
Different assets carry different premiums:
- Equity risk premium (ERP). The expected return on the stock market above Treasuries. It is central to valuing stocks and setting long-term return assumptions.
- Credit risk premium. The extra yield on a corporate bond over a Treasury of similar maturity, known as its Credit Spread.
- Others. Investors also demand premiums for illiquidity, for small companies and for longer bond maturities.
What to keep in mind
- It is not guaranteed. A premium is an expectation over long horizons. Stocks have trailed Treasuries over stretches of a decade or more, including 2000–2009.
- It changes. Premiums tend to widen in panics, when investors demand more for holding risk, and to shrink in calm, optimistic markets. That variation is a big part of why stock prices move more than earnings.
- Estimates differ widely. Practitioners use equity risk premiums ranging from roughly 3% to 7%, and small changes produce large differences in valuation.