Finance: What is risk premium?

What is risk premium? Risk premium is the amount of excess return or yield that a bond must pay in order to compensate for the additional default risk calculated on the bond above the risk free benchmark. Bonds with lower than AAA rating with comparable coupon and maturity will cost less and yield more than their peers depending on rating. Thus, a BBB bond will have a higher yield in the market that a AA- bond due to its perceived higher risk of default.

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Transcript

00:18

Coke or GOOG or some other behemoth company of those

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bonds carry more risk than US government paper And if

00:25

you bought the stocks I even equities not the bonds

00:28

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

00:30

more risk Well historically stocks have swung up and down

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violently in short periods over time but over long periods

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

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there is more perceived risk investors will demand more potential

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reward Yeah the key idea here every investment carries more

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risk than US government paper So on top of whatever

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U S Government bonds air yielding investors tag on top

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of them a premium investment return that they require to

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be interested in investing So if say a five year

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

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looking at investing in bonds backed by a controversial low

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

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of bankruptcy there right Well then those bonds will carry

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meaningful E a higher yield than the US government five

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

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back its bond is modest well then maybe that premiums

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only one percent on top and those five year bonds

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yield in a four percent If the risk is big

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they might have to yield eight or ten or fourteen

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percent or more But those were extremely high rates at

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

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and backing the money already has one foot in the

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grave So now let's go to a completely different way

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of thinking about this extra risk your local diner Think

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of our risk free five year U S Government bonds

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of yielding three percent and being priced like a dinner

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salad which is the cheapest item on the menu right

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here So everything else will cost more than that salad

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

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

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But you could also describe that cost to the angry

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waitress or friendly robot as dinner salad plus four bucks

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The premium tacked onto the salad price is four dollars

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for the burger Well risk is priced and described the

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same way there has to be added investment return to

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reflect the added risk to the investor on any given

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deal Be careful though There's inherent risk even if all

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you do is order to the salad Especially if there's

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been a romaine lettuce E Coli warning recently issued by

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