How to Calculate Risk Premium

Many investors know that getting their financial goals requires a certain amount of risk. You must know how to calculate risk premium if you are going to invest your money. It is essential to understand the connection between risk and reward in order to make decision between choices of your investments. Risk premium is actually explained as the difference between the rate of return on common stock and the government securities.

One can easily calculate the risk premium in very simple steps.

Steps to calculate

  • You should make a list of the investments in which you are interested. You should segregate them into two categories which are
  1. Common stocks
  2. Treasury securities
  • Common stocks are issued by those companies which are publicly traded and which are available for buying on the stock market.
  • Government issues the treasury securities.
  • You should take the common stocks and evaluate their previous performance during a specific time period. Especially, you should find out the average return on equities. This percentage rate is a part of a report of each and every company to the investors.
  • You should compare the average return for securities or treasury bills for the same time period. This value is available on the treasury board’s website or you can get it from any bank.
  • Compute the risk premium by deducting the average return for securities or treasury bills from the average return of common stocks. This value you obtain now is the risk premium. This is the standard mathematical calculation.
  • This method is an easy and quick method to compute the premium; however, it is not the exact method.
  • You should use the geometric average to compute the exact risk premium. This can be calculated by taking the final value and dividing it by the initial value. You should multiply the figure obtained by 1 / n.

Here n is the number of periods in the average.

  • You should take this answer and deduct it from 1. The figure obtained now is the risk premium percentage.
  • Now you should select the exact calculation technique based on the future use of the information. If you suppose that the pattern will be the same as in past in future then the mathematical calculation is the best method for calculation.
  • But for a longer time period, where the future pattern cannot be assumed, the geometric average method is better to use.

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  4. How to Calculate Stock Index
  5. How to Calculate Stock Turnover
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