Risk premium

The risk premium is the extra cost that any given debt issuer has, compared to another debt issuer that is considered as a reference and is assumed with less risk.

The risk premium is a reward or “premium” (hence its name) that is awarded to the investor for investing in a risky asset rather than investing in one with less risk (that is, for risking more). It is commonly used to compare the profitability  or interest of a risky asset with that of the risk-free asset .

The risk premium is a concept that is used as a measure of risk. Of course, first of all, it is important to know that the concept of risk premium is a very broad concept. Although it is true, everything must be said, which is normally used to designate the difference between the cost of a country’s debt (with more risk) versus the debt of a reference country (with less risk).

From now on we will explain its calculation and the different contexts in which this concept is used. That is, we will talk about the risk premium when talking about countries, as well as when talking about private companies.

Calculation of the risk premium

The risk premium formula is very simple. To calculate the risk premium, you only need to know the interest rate offered by a debt security and to know the interest rate of the reference security. The formula to calculate the risk premium is:

Risk premium = i Country with the highest risk – i Reference country

Where:

i = Interest rate offered by the country’s debt

Country risk premium

Just like when we ask for a loan in a bank we have to repay it with interest , companies and governments also have to repay their loans with interest. The risk premium represents the extra interest that a company must pay with respect to the Government (for having more risk). Or, the extra interest paid by a country with less credit compared to another country with more credit, known as a country risk premium .

In this way, the country risk premium is the difference between the interest rate that a country pays when it borrows and the one paid by another country that offers less interest. Thus, the higher the risk of one country with respect to another, the higher its country risk premium and the higher the interest rate of its debt.

Viewed from another perspective, the risk premium is the extra return that investors require to invest in one country compared to that demanded in another country. Therefore, the risk premium is a good indicator of the confidence that investors have in the strength of an economy. In Europe, Germany’s debt is normally considered as lower risk debt.

Business risk premium

The risk premium is also used to measure the extra cost that companies have to pay to finance themselves with respect to the largest company in the sector or with respect to the cost of financing from the Government. It is common to see in financial reports, concepts such as that a company has a risk premium of X points against its sector or against another company. That is, the extra cost that the company pays to finance itself in the financial markets. This extra cost is paid to compensate the investor for assuming a higher risk compared to the reference company.

Example of calculating the risk premium

For example, the interest on the debt of Spain less the interest on the debt of Germany. The risk premium for Spanish public debt is generally calculated with respect to the German one. That is, the difference between the interest rate of the debt issued by the Treasury of Spain with respect to that issued by the Treasury of Germany. The maturity period of the debt must be the same, generally it is usually calculated with 10-year bonds . If the interest rate paid by Spain for its 10-year debt is 5% and the interest rate paid by Germany is 2%, the difference will be 3%. Expressing in basic points we will say that the risk premium for Spain is 300 points, because Spain pays 3% more for the interest on its debt than Germany.

Spain risk premium = i ESP – i ALE = 5% – 2% = 3%

In this case, the risk premium would be 3%. Put another way, the risk premium is 300 basis points. 1% represents 100 basis points.

Another example could be the risk premium of  Inditex bonds (debt) with respect to Spanish government bonds. If Inditex pays 7% 10-year bonds for its bonds and Spain 5%, Inditex’s risk premium is 2%. Or, 200 basis points.

 

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