A risk premium is the percentage of return in addition to the risk-free rate offered by security. To calculate the risk premium, we simply deduct the risk-free rate (Rf) from the market rate of return (Rm) offered by security.
Since the Rf represents the risk-free rate that is available for investment anywhere as there is no default risk attached to investing with the government. The premium is something that a company is offering in addition to Rf, against some risk that is inherited in that security.
Assume the Rf is 4% and the Rm offered by IBM stock is 9%. In this case, the risk premium is:
Risk Premium = Rm – Rf
Risk premium = 9% - 4% = 5%
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