Risk Premiums

Time and Risk

Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.

Time is a component of risk for varying reasons; however, the two most common are related to (1) the increase in general uncertainty rising with the time horizon and (2) reinvestment risk.

In our everyday lives, we are faced with momentary uncertainties that become increasingly harder to predict as we move from a five-minute horizon to a five-day, five-month, or even five-year period. This same phenomenon is true of financial assets. Though the attribution of acceptable inflation can be incorporated into an investment return, the actual pricing and resulting purchasing power of the investment at maturity is unknown and the uncertainty increases with time. Therefore, investment returns compensate holders for the time to maturity via a risk premium.

the graph hortinal line is called beta and there is line going vertically up from the middle called the asset return line. The graph line starts at the bottom left and moves upward to the right crossing the asset return line. the area where the line crosses the asset return line and down to beta is called risk-free rate of return.
Return Expectations Based on Risk Analysis

In finance and economics, as depicted in the graph above of the capital asset pricing model, risk is evaluated to set the boundary for acceptable return.

Risk premiums compensate holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment. For example, if asset A and asset B both pay a 5 percent coupon on an annual basis, but asset B matures in five years and asset A matures in one year, all else equal (asset quality and issuer solvency), we would expect asset A to trade at a higher price than asset B. Remembering that yield and price are inversely related, the higher price on A implies that it has a lower yield than B. The differential in yield can be attributed to a risk premium for time to maturity.

Another aspect of the time horizon is reinvestment risk. For some investments, there is a potential for an issuer to call or redeem a security prior to maturity. Given that at the time that the investment is called, prevailing rates may be lower than at the purchase of the asset, the holder is taking a reinvestment risk at the time of purchase. To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.

Systematic Risk

It’s important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from a market structure or dynamics that produce shocks or uncertainty faced by all agents in the market. For example, government policy, international economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how diversified it is.

Maturity Risk Premium

The level of risk in investments is taken into consideration. This is why very volatile investments like shares and junk bonds have higher returns than safer ones like government bonds.

The extra interest charged on a risky investment is the risk premium. The required risk premium is dependent on the risk preferences of the lender. If an investment is 50 percent likely to go bankrupt, a risk-neutral lender will require their returns to double. For an investment that normally returns $100, they would require $200 back. A risk-averse lender would require more than $200 back, and a risk-loving lender less than $200. Evidence suggests that most lenders are in fact risk-averse.

Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans are exposed to more risk of default through their duration.

Licenses and Attributions

Tools of Finance from Boundless Economics by Lumen Learning, originally published by Boundless.com, is available under a Creative Commons Attribution-ShareAlike 4.0 International license. UMGC has modified this work and it is available under the original license.

Risk from Principles of Finance by The Open University of Hong Kong is available under a Creative Commons Attribution-ShareAlike 4.0 International license. © Wikibooks. UMGC has modified this work and it is available under the original license.