Defining risk premiums
Investors have different tolerances when it comes to risks. Some are more aggressive and brave, and some are conservative. For instance, the bonds with lesser default risks are high-quality ones from sturdy corporations and businesses which earn hefty and regular profits. On the other hand, bonds with more risks come from less established companies and have unpredictable profitability.
Here is where risk premium enters the picture. A risk premium is like a payment or compensation to investors depending on how much risk they tolerated for the asset or investment they chose over a risk-free one.
Finding logic for risk premiums
Imagine this: today is 2021, and you are a nurse. You are hesitating to report for work because of the COVID-19 pandemic. You are afraid that you might catch the virus as well, so you are planning to resign. The hospital is willing to give you a higher wage to prevent you from quitting. It means that aside from your regular salary, you will be getting hazard pay. You can think of this hazard pay as a factor that prevents you from quitting or funds that you can use to pay for bills if you, unfortunately, caught the virus for working.
This example is nothing different from risk premiums. Think of the investors as yourself, the nurse. Instead of choosing the risk-free asset, they chose a risky investment because it might give them better profits. Hence, business owners with risky investments need something like a hazard pay for the investors. They deserve a bonus aside from the money they can get if they took risk-free investments. However, risk premiums will not be handed out unless the business thrives and succeeds.
Another way to think of risk premiums
Businesses or companies will not risk some or even all of their capital for nothing. So, they take risks because they want to achieve more than what is standard and predictable. For example, investments we find in well-penetrated markets are more or less predictable from the riskier ones. Hence, more risks mean an equal possibility of earning more and losing more. If the business owner saw that the risk was worthwhile as it generated a lot, it would only be rightful and fair to reward and compensate the investors who believed or entrusted their money with him. It is one of the main reasons why other investors prefer risky investments. Conservative investors might not do this, but this a perspective they can look at if they do not understand why someone would bet their money on risky investment instead of being on the safe side.
Two sides of the coin
Should a business owner or borrower consider offering risk premiums to investors? A borrower should assess how confident he is in his business and if it is a practical idea because they should pay investors risk premiums or high-interest rates. Also, paying a risk premium might lessen the business’s budget. Hence, there will be cost-cutting that will lead to less efficiency and less profitability. In this case, the risk premium will do more harm than good. On the other hand, investors should also think long and hard before taking risk premiums. Some businesses fail, and when they do so, they will also fail to pay.
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