Risk-free rate and equity risk premium

4.4

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Practically speaking, you know that there is no investment that carries zero risk. But for the purpose of understanding how the risk levels of different investments differ, we need a baseline. And with that baseline, you can compare the risk of different investments, categorize them as high-risk or low-risk assets, and even quantify that risk. 

Here is where two important concepts come in, namely the risk-free rate of return, and the equity risk premium.

Risk-free rate of return: An introduction

The risk-free rate of return is exactly what it sounds like. It is the theoretical rate of return from an investment that is risk-free. Now, when we say risk-free here, we are generally referring to default risk and investment risk. In practice, no investment carries zero risk. But generally speaking, investors consider government-backed securities to be as close to the zero-risk mark as possible.

What is the significance of the risk-free rate of return?

Why do you need to know the risk-free rate of return, as an investor? Well, this rate basically indicates the amount of returns that you can get with zero risk, right? In other words, it is the minimum rate of returns you can expect in the market, without taking on any risk.

So, if you want to invest in any other asset that has some level of risk, then you need to make sure that it offers you returns higher than the risk-free rate. This is because you will be taking on added risk. Therefore, you will naturally expect higher returns.

For example, take two assets: asset A and asset B.

  • Asset A comes with zero risk and offers returns of 5%. So, the risk-free rate of return is exactly that. Five percent.
  • Asset B carries some level of risk. Now, at what level of returns would you be willing to invest in asset B? Let’s see.

Particulars

Risk-free rate

Returns from asset B 

Course of action

Reason

Scenario 1

5%

4%

You do not invest in asset B.

It offers lower returns than the risk-free rate, and it comes with a higher level of risk.

Scenario 2

5%

5%

You do not invest in asset B.

It offers the same returns as the risk-free rate, but it carries some level of risk.

Scenario 3

5%

6%

You invest in asset B.

It comes with higher risk, but also offers higher returns.

How do you calculate the risk-free rate of return?

Recall how government securities/bonds come closest to being zero-risk? So, that’s what we’ll be taking into account in the formula, which goes like this.

Risk-free rate of return = [(1 + Government Bond Rate) ÷ (1 + Inflation Rate)] - 1 

For example, let’s take a set of hypothetical data:

Particulars 

 

10-year government bond rate

6%

Inflation rate

4%

Risk-free rate of return

[(1 + 6%) ÷ (1 +4%)] - 1

= 1.92%

Equity risk premium: An introduction

It is a well-known fact that equity is a high-risk-high-return investment option. What does this mean, in the context of risk-free returns as we saw above? Well, it simply means that equity carries a higher risk than zero-risk investments. But correspondingly, it also tends to deliver returns higher than the risk-free rate of return. This difference in the returns is what we call equity risk premium.

Also known simply as equity premium, the equity risk premium is the additional return that an equity asset generates, over and above the risk-free rate of return.

In other words, the expected returns from a high-risk asset like equity is the sum of the risk-free rate and the equity risk premium. Let’s note this formula down. It’s going to be of use in the next chapter.

Expected returns from an asset = Risk-free rate of return + Equity risk premium

What is the significance of the equity risk premium?

The equity premium gives you a good idea of how much excess returns you can expect to earn for the increased risk you take on when you invest in a high-risk asset. It helps you pitch the risk against the rewards and see if the investment is favourable for you, overall.

For instance, if the equity premium for an asset is 16%, but it carries a risk of around 35%, the trade-off may be too high for moderate and conservative investors. Aggressive investors, on the other hand, may be open to taking this level of risk for this level of excess return.

Wrapping up

So, now that we’ve discussed these two important concepts, you’re no doubt ready to explore the Capital Asset Pricing Model. Curious about that? You know what to do then. Simply head to the next chapter to find out more.

A quick recap

  • The risk-free rate of return is the theoretical rate of return from an investment that is risk-free.  
  • In practice, no investment carries zero risk. But generally speaking, investors consider government-backed securities to be as close to the zero-risk mark as possible.
  • So, if you want to invest in any other asset that has some level of risk, then you need to make sure that it offers you returns higher than the risk-free rate. 
  • The formula for calculating the risk-free rate is: [(1 + Government Bond Rate) ÷ (1 + Inflation Rate)] - 1
  • Also known simply as equity premium, the equity risk premium is the additional return that an equity asset generates, over and above the risk-free rate of return.
  • In other words, the expected returns from a high-risk asset like equity is the sum of the risk-free rate and the equity risk premium.
  • The equity premium gives you a good idea of how much excess returns you can expect to earn for the increased risk you take on when you invest in a high-risk asset.
  • It helps you pitch the risk against the rewards and see if the investment is favourable for you, overall.
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