Risk Premium

What is risk premium ? Risk premium comes from the notion that, when you invest in pretty much anything other than U.S. Government debt, there is more risk. Like, even buying the bonds of Disney or Coca Cola or some other behemoth company.

Those bonds, notionally at least, carry more risk than buying U.S. Government paper. And if you bought the stocks, not the bonds, of one of those behemoth companies, then there’s waaaay more risk.

Historically, stocks have swung up and down violently over time. But they’ve also gone up over time. Regardless, where there is more perceived risk, investors will demand more potential reward. Yeah...duh.

The key idea here: Every investment carries more risk than U.S. Government paper, so on top of whatever U.S. Government bonds are yielding... investors tag on top of them a premium investment return that they require to be interested in investing.

So if, say, 5-year U.S. Government bonds are yielding 3 percent, and you’re looking at investing in bonds backed by a controversial company, where there is at least some tangible risk of bankruptcy, then those bonds will carry meaningfully higher yield than the 5-year paper.

If the risk that the company doesn't pay back its bonds is modest, then maybe that premium is only 1 percent and those 5-year bonds yield 4 percent. If the risk is big, they might yield 8, 10, 14 percent or more. But at those extremely high rates, the market is telling you that the company already has at least one foot in the grave.

So now let’s go to a completely different way of thinking about this extra risk: your local diner. Think of our risk-free 5 year U.S. Government bonds as yielding 3 percent, and being priced like a dinner salad, which is the cheapest item on the menu. So everything else will cost more than that salad. Croutons included.

So then, when you’re ordering if you wanted a burger, its total gross cost is 7 bucks, but you could also describe it to the angry waitress or friendly robot as dinner salad plus 4 bucks. The premium tacked onto the salad is 4 dollars.

Well, risk is priced and described the same way. There has to be added investment return to reflect the added risk to the investor on any given deal. Be careful though: There’s inherent risk even if all you do is order the salad especially if there’s been a Romaine lettuce E. coli warning recently issued by the CDC...