Concept 4: Risk premium

We know that risk is the other side of return. When we invest money, our decision to invest in that asset is partly based on our estimate of the return it generates and the relative risk it carries. It’s a trade off. If you want more returns, you have to take more risks.

Risk may have different meanings. To investors, risk is the likelihood that the outcome of an investment is different from what was calculated.

One point to note here is that – the term risk is a combination of two parts- systemic risk and unsytemic risk.

  • Systemic risk is the risk beyond the control of any investor. For example – recession, war, inflation etc. It’s also called non diversifiable risk. Once the investor is in the market, he has to face it.
  • Unsytemic risk is otherwise called specific risk – it is the risk specifically associated with company or an industry and is due to factors specific to a company/industry. For example- labour strike, Product failure etc. Unsystematic risk can be mitigated through investing in diversified assets.

In short, only a part of the risk can be mitigated. The other part is uncontrollable.

RISK FREE RETURN

Risk free return is the returns generated by investing in risk free assets. Investments where both the capital and the interest are guaranteed are called risk free assets. Generally, government bonds are considered to be risk free and the rate of return on such bonds are considered as the risk free rate of return.

So risk free return is something anybody can earn by simply investing in that risk free assets. Let’s assume that government bonds promise 6% return.

Now, let us further assume that the stock market index like Sensex has given a return of 16%. Anyone who has invested in stocks that constitute the index will be able to earn that 16% . This excess return earned over and above the risk free rerun is called the risk premium.

In our example, the risk premium would be 16-6 = 10%.

So we can split the total return from stock market investment as:

  • 10% risk premium + 6% risk free rate = 16% from stock market.

So, from the above example it follows that if an investment is risky just like the stock market index, the ‘risk premium’ to be earned is 10%.

We forgot to consider volatility!!

Recall the topic on beta.  Let’s assume that the beta of a particular stock ‘Axl ltd’ is 1.5. That means, the stock’s volatility is 1.5 times than the overall market. The overall market risk premium is computed as 10%. Hence the risk premium to be earned from investing in that particular stock would be 10% x 1.5 = 15%.

That’s only risk premium! add to it the risk free return of 6% and you get 21% as the target retrun for taking the risk of investing in that stock.

This theoretically is the default model for measuring investment risk – called the ‘Capital Asset Pricing Model’ or the CAPM formula.

In other words, the CAPM approach helps you to decide whether or not the current price of a stock is consistent with its likely return – that is, whether or not the investment is a bargain or too expensive.

Formula for CAPM

The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.




Or to put it i simple terms-

  • Expected Return = risk-free rate + Beta x (Market return – risk-free rate)

Risk free rate in Indian context.

For Indian investors, the risk free rate is 8% now. Risk free rate of India can also be measured in comparison with –

  • The US treasury bonds which is supposed to be the safest of all bonds.
  • The default spread of investing in India when compared to US treasury bonds according to international rating agencies like Moody’s or standard and Poor’s.
  • And, the standard deviation in returns from equity and bonds.

Such an exercise may not be required in this ever changing global scenario. Moreover, average Indian investors have limited opportunities to invest overseas.

Hence, the risk free return for Indian investors can be safely assumed to be the Return from Government of India bonds.

To conclude –

  • Risk free return rate becomes the primary base from which other valuations are derived.
  • CAPM approach helps to calculate what return on investment we should expect.
  • This rate of return expected by investors is called ‘cost of equity’ from the company’s point of view. That is, the compensation an investor demands in exchange for parking his funds in stocks and bearing the risk of ownership.
  • There are other models to calculate risk premiums and cost of equity.
  • Three factors determine the risk premium: (a) the systemic risk of the investment; (b) the average expected return for the market relative to an index and (c) the return expected from a risk-free investment.

Hope you are clear about risk premium.

You may like these posts:

  1. Using Beta to gauge volatility.
  2. What is the risk involved in investing?
  3. Concept 3: Margin of Safety

3 Responses to “Concept 4: Risk premium”

Avinash

February 1, 2012 at 1:13 pm

why should you multiply beta with the risk premium? i dint understand that.

J Victor

February 1, 2012 at 1:24 pm

Risk premium or the extra return that stock market gives over and above risk free rates is based on the index.

Each stock has a beta measure which is it’s relative volatility to the overall market represented by an index. So if the beta of a stock is 3, it implies that when the market index moves 1%, the stock moves 3 %.

so, to find the risk premium of investing in a particular stock, you need to take the beta of the stock into consideration.

Ritesh sawarkar

March 18, 2016 at 11:53 am

In my whole educational life..I couldn’t understand CAPM….
And you simply explained in few lines… Hats off to Mr.Victor….

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