How Can Risk Influence Risk Premium Essay
How Can Risk Influence Risk Premium
Risk and return are the fundamental basis upon which investors make their decision whether or not they should invest in a particular investment. How they are related and the influence between the two, is the decision making process that all investors must weigh up. This essay will show how risk can influence risk premium, outlining their relationship and how risk and return are related. Within any investment there is a certain amount of risk, which must be taken into account by an investor when deciding to invest. Risk is defined as the chance of financial loss or, more formally the variability of returns associated with a given asset.
This concept in finance is the idea that all investment carries a risk, the higher the risk, the greater the return, however the adverse is also relevant, when the risk of an investment is lower the return is expected to also be lower. However, with all investment there is never a guarantee of return. Return is the total gain or loss experienced on an investment over a given period of time. It is measured by the asset’s cash distributions plus change in value, divided by its beginning-of-period value. (Gitman, et al. , 2011, p. 08)
Returns on investment are the motivation to all investors, however as all investment carries a risk, the investor must have a required and expected return on the investment. Expected return, is the return that an asset is expected to produce over some future period of time, while required return, is that which an investor requires an asset to produce if he/she is to be a future investor in that asset. It is here that we see the relationship between risk and return. With the expected and required return on an asset, an investor can calculate the return of an asset and its risk. Kidwell, et al. , 2007, p. 307)
To better understand this relationship we must analyse risk premium. Risk premium refers to an asset’s expected rate of return and how that exceeds the risk free rate. The risk free rate is the interest rate of a stable investment usually a government bond or Treasury bill, which is used as a stabilizer and market equivalent in the calculation of the risk and return. (Kidwell, et al. , 2007, p. 307) The required rate of return is therefore based on the expectations of the investor. Risk premium is the compensation for making and undertaking an investment and risk.
It is here that we bring all the above mentioned components of risk, return, and risk premium together to formulate: Required rate of return = Risk-free rate of return + Risk premium From this equation we see how risk can influence the risk premium and in turn affect the required rate of return. As risk premium is based on the investor’s compensation for undertaking the risk, we can surmise that the higher the compensation wanted by the investor, the higher the risk will have to be to gain the required rate of return.