Risk-Free Rate Of Return

Finance Allah shmoop What is risk premium No it's not

This movie in three D risk premium comes from the

notion that when you invest in pretty much anything other

than US government debt there is more risk in that

other investment like even by the bonds of Disney or

Coke or GOOG or some other behemoth company of those

bonds carry more risk than US government paper And if

you bought the stocks I even equities not the bonds

of one of those beam off cos Well there's way

more risk Well historically stocks have swung up and down

violently in short periods over time but over long periods

of time they've gone up Ah lot Well regardless where

there is more perceived risk investors will demand more potential

reward Yeah the key idea here every investment carries more

risk than US government paper So on top of whatever

U S Government bonds air yielding investors tag on top

of them a premium investment return that they require to

be interested in investing So if say a five year

U S Government bond is yielding three percent and you're

looking at investing in bonds backed by a controversial low

warlord Somalian company Well there's at least some tangible risk

of bankruptcy there right Well then those bonds will carry

meaningful E a higher yield than the US government five

year paper If the risk that the company doesn't pay

back its bond is modest well then maybe that premiums

only one percent on top and those five year bonds

yield in a four percent If the risk is big

they might have to yield eight or ten or fourteen

percent or more But those were extremely high rates at

least these days The market's telling you that the company

and backing the money already has 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 five year U S Government bonds

of yielding three percent and being priced like a dinner

salad which is the cheapest item on the menu right

here So everything else will cost more than that salad

crew tones included So then when you're ordering if you

wanted a burger it's total gross Cost is seven bucks

But you could also describe that cost to the angry

waitress or friendly robot as dinner salad plus four bucks

The premium tacked onto the salad price is four dollars

for the burger 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 to the salad Especially if there's

been a romaine lettuce E Coli warning recently issued by

the CDC And you do not want to go there 00:02:32.288 --> [endTime] My God