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Wednesday, February 16, 2011

Understanding risk premium in finance

Risk premium is a financial value that equals return on investment over and above the risk free rate. The risk free rate is the amount an investor receives for investment with very little risk. For example, a government issued savings bond has a low return in comparison to a higher risk bond such as a corporate junk bond. If a risk free government bond has a rate of return of three percent, and the corporate junk bond has a rate of seven percent, then the difference between the two is the risk premium. In this case the risk premium would be four percent.

In finance, risk premium is an important component of risk management as it helps corporate and business decision makers assess the value of an investment via its potential risk and reward to revenue. The more accurate the risk forecasts are, the greater the utility of the risk premium measurement. For example, if a project is estimated to carry a risk premium of five percent, and the foretasted ROI is accurate, then cash-flow management, and liquidity can be planned and implemented for other business functions. The accuracy of forecasting risk premiums is consequently of great relevance if large financial decisions are made using the data. The video below explains risk premium further:


Calculation of risk premium


How risk premium is calculated in finance helps investors determine whether or not the return on an investment justifies the investment risk. In other words, if a return on investment doesn't price in risks such as liquidity risk, market risk, and interest rate risk. For example, a bond that provides a return of three percent might not provide as high a return as bonds issued six months later. This is the interest rate risk inherent to investing in the bond even though it is a risk free bond. The difference between the interest rate risk and the risk free rate plus the risk premium is the opportunity cost.

Calculating risk premium is different from forecasting risk premium because historical values are used. Since return on investment is known for past investments, historical risk premium is easily calculated using basic arithmetic. For future investments however, calculating risk premium can be more complex.

Financial models that measure risk premium


In a study performed by Aswath Damodran, several forms of risk measurement including the Capital Asset Pricing Model (CAPM), Arbitrage Pricing Model (ARM), Multi-Factor Model and Proxy Model are outlined. Several of these models use a calculation called beta that measures risk. As Damodran points out, in so far as beta calculations are used to determine risk in CAPM, the values that go into the beta are broad market based indicators and somewhat irresolute i.e. subject to any number of factors of change. Similar variability exists in the measurement of beta for ARM, and the Multi-Factor Model,

Determining which risk model to use is a matter of applicability. For example, if risk is less a function of economic factors and more operational in nature, then the Multi-Factor Model would be less useful. In such case, an in house risk assessment might be useful to a company. For example, a producer of parts for use in equipment might incorporate operational performance of manufacturing machinery into a risk model so as to account for shut-downs, repairs or lower capacity utilization.

In this case, the replacement risk variables such as machine utilization and cost can be calculated as lost ouput of works in progress as a function of product demand. In other words, the risks to any investment should be identified and assessed realistically rather than haphazardly using risk metrics that don't necessarily apply.

Sources:

1. http://bit.ly/9egOlQ (NYU: Stern School of Business)
2. http://bit.ly/aN6pYh (Financial Regulatory Authority)
3. http://bit.ly/cerRlq (Investopedia)