What is risk premium
A risk premium is the extra return investors demand for holding a risky asset instead of a safer one.
The safer asset is usually a short-term government bill in the same currency. The return on that bill is called the risk-free rate. Anything an investor expects above it is payment for taking risk.
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Formal definition
For an asset with expected return E[R] and a risk-free rate R_f:
Risk premium = E[R] − R_f
The equity risk premium (ERP) is the same idea for the stock market as a whole: the expected return on a broad equity index minus the risk-free rate. In the CAPM model, a single stock's premium is its beta multiplied by the ERP.
Edge cases experienced readers should keep in mind:
- Ex-ante vs ex-post. The premium is an expectation. The realised excess return over a given period can be negative. A negative realised return does not mean the premium was negative.
- It moves over time. Premiums rise when fear rises. In a flight to quality, prices of risky assets fall partly because investors demand a larger premium.
- The risk-free rate is not universal. A rupee investor and a dollar investor use different risk-free rates. Comparing yields across currencies mixes in currency risk.
- Several premiums can stack. These include a credit premium for default risk, a term premium for longer duration, a liquidity premium, and a country premium in emerging markets.
Worked example (hypothetical)
Use letters instead of real figures:
| Asset | Yield |
|---|---|
| Government treasury bill (rupees) | R_f |
| Corporate bond, same maturity (rupees) | R_f + S |
The corporate bond pays an extra S. That S is its risk premium, and in bond markets it is usually quoted as a credit spread in basis points.
If the company's outlook worsens, investors want a larger S. The bond's price falls until its yield offers that larger premium.
In Pakistan, short-term government yields usually track the SBP policy rate. The latest decision we track is: SBP policy rate raised by 50 bps to 12% with effect from 27.10.2026 (MPC). A change in that rate shifts R_f. It does not by itself change S.
Where you see the term
- News. You will see it in reports on sovereign Eurobond spreads, "country risk" and markets turning risk-off.
- Research reports. Equity analysts state an assumed ERP when they value stocks or set target prices.
- Trading platforms. MetaTrader does not show a "risk premium" field. Interest-rate differences between currencies do appear indirectly in overnight swap fees and in forward points, which are linked to covered interest parity.
A risk premium is compensation investors demand. It is not a return anyone is guaranteed. Leveraged forex and CFD trading can lose money fast, whatever premium a market seems to offer.
Related terms
- Credit spread
- Beta and alpha
- Currency risk
- Fat tails and tail risk
- Fundamental analysis
- Trading glossary
Frequent questions
What is risk premium in simple words?
It is the extra return people expect for holding something riskier than a safe government bill.
What is the equity risk premium?
It is the expected return of the stock market as a whole minus the risk-free rate.
Can a risk premium be negative?
The expected premium for a risky asset is normally positive. The realised excess return over a given period can be negative.
Is a higher risk premium a sign to buy?
No. A higher premium means investors see more risk. It is not a signal, and the higher expected return may never arrive.
How does the policy rate affect risk premium?
The policy rate moves the risk-free rate. The premium is measured on top of it, so the two are tracked separately.