Risk premium plus Risk free rate of return is the rate of return demanded on a security by investors in the market.
Concept Definition and Explanation
Rate of return required on a security or asset has three components.
1. Pure time value of money.
2. Inflation premium
3. Risk premium
As securities are issued by corporate entitiies engaged in business activities, risk arises due to the following sources of risk.
1. Operating risk: Business organzations have fixed costs and as sales vary from year to year, in some years contribution from sales can be less than the fixed cost leading to reporting of loss by the company.
2. Financial risk: Many business organizations borrow to increase the capital employed in the business. This would lead to fixed interest cost commitment. In years when operating profits are low or small, the fixed interest cost will depress after-financial cost profit.
3. Liquidity risk or market risk: Securities are to be sold in the secondary market, and there are price fluctuations in the market depending on the liquidity conditions in the market.
Investors demand a risk premium to compensate them for the variability of return that arises due to various sources of risk of the security. This risk premium forms part of expected return as well as nominal return specified on fixed income securities.
Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management
Equity Risk Premiums (ERP) : Determinants, Estimation and Implications: Empirical Study 2011 Edition by Aswath Damodaran
Blog Post by Aswath Damodaran, February 25, 2011