Risk premium

The inputs for each of these variables and the ultimate interpretation of the risk premium value differs depending on the application as explained in the following sections.

Regardless of the application, the market premium can be volatile as both comprising variables can be impacted independent of each other by both cyclical and abrupt changes.

Additionally, a general observation regardless of application is that the risk premium is larger during economic downturns and during periods of increased uncertainty.

In the equity market, the riskiness of a stock can be estimated by the magnitude of the standard deviation from the mean.

Investors also analyse many other factors about a company that may influence its risk such as industry volatility, cash flows, debt, and other market threats.

[8] The formula can be rearranged to find the expected return on an investment given a stated risk premium and risk-free rate.

For example, if the investor in the example above required a risk premium of 9% then the expected return on the equity asset would have to be 12%.

[9] Risk premiums are essential to the banking sector and can provide a large amount of information to investors and customers alike.

[10] This less the interest rate set by the central bank provides the risk premium.

Stakeholders can interpret a large premium as an indication of increased default risk which has flow on effects such as negatively impacting the public's confidence in the financial system which can ultimately lead to bank runs which is dangerous for an economy.

[11] One of the most important applications of risk premiums is to estimate the value of financial assets.

In Finance, CAPM is generally used to estimate the required rate of return for an equity.

This required rate of return can then be used to estimate a price for the stock which can be done via a number of methods.

[12] The formula for CAPM is: In this model, we use the implied risk premium (market return less risk-free rate) and multiply this with the beta of the security.

This beta is generally found via statistical analysis of the share price history of a stock.

Therefore CAPM aims to provide a simple model in order to estimate the required return of an investment which uses the theory of risk premiums.

This helps to provide investors with a simple means of determining what return an investment should be relative to its risk.

[18] CEO's in industries with high volatility are subject to increased risk of dismissal.

[20] Due to this, and assuming there is demand competition within the labor market, they often require a higher remuneration than CEO's in non-volatile industries as a risk premium.

[19] The option value of whether to invest in invasive species quarantine and/or management is a risk premium in some models.

For example in the northern United States, Fusarium head blight is a constant problem.

Then in 2000 the release of a multiply-resistant cultivar of wheat dramatically reduced the necessary risk premium.

The total planted area of MR wheats was dramatically expanded, due to this essentially costless tradeoff to the new cultivar.

[22] Estimates of costs of research and development - including patent costs - of new crop genes and other agricultural biotechnologies must include the risk premium of those which do not ultimately obtain patent approval.

Contestants requiring a minimum risk compensation of less than $300 will choose a door instead of accepting the guaranteed $500.