Understanding Risk Premium

Calculating the Risk Premium for an investment can be complicated, but understanding Risk Premium is simple. The riskier the borrower or the investment, the higher the interest rate the Lender will require. Not complicated, common sense.

Let’s spend a moment going a little deeper into Risk Premium.

The U.S. Federal Government is considered the safest borrower in the world, so it demands the lowest interest rate when it borrows (in the form of Treasury Bills, Notes, and Bonds). You can find this rate below in the Rates widget graciously provided by “theFinancials.com”. If you look toward the bottom of the list, you will see “10-Yr Treas”. The rate to the right is the yield you’ll receive if you were to “lend” money to the Federal Government for 10 years*.

In Risk Premium terms, this is the “Risk Free Rate”. That means that from a lender’s perspective (you as the investor), there is no risk in lending to the Federal Government. Hence “Risk Free”. So, when you lend to anyone else, you should demand a “premium” to the “Risk Free Rate”. The amount the lender will require from a borrower, on top of the Risk Free Rate, is what is called the “Risk Premium”.

For Example:

10 Year Treasury is 2%

Your brother-in-law wants to borrow money for a “sure-thing” investment. You agree but tell him he has to pay you 10% interest a year.

So to calculate the Risk Premium:

Your Interest Rate minus the Risk Free Rate = Risk Premium

10% - 2% = 8%

You ask, “Why is this important?” Whenever any lender is going to lend, or a Borrower needs to borrow, determining what Risk Premium to request requires deciding on the “riskiness” of the investment. The Risk Premium is then combined with other factors such as term of loan (length), and current and future inflation rates to decide on the rate the borrower needs to pay.

* The yield listed is not actually the rate the U.S. Treasury is currently paying but the rate they would likely pay if they were to issue new debt to that tenor today. The rate in the widget is the rate in the “secondary” market. More on the “Secondary” market for Treasuries can be found at the Federal Reserve website: http://www.federalreserve.gov/pubs/bulletin/1999/1299lead.pdf