A risk premium is the investment return an asset is expected to yield in excess of the risk-free

rate of return. An asset's risk premium is a form of compensation for investors. It represents
payment to investors for tolerating the extra risk in a given investment over that of a risk-free
asset
What Is Risk Premium?
Risk premium refers to the additional return an investor expects to receive from
an investment to compensate for the risk associated with holding that asset.

In essence, it represents the difference between the expected return on a risky asset and the
return on a risk-free asset, such as government bonds.

Risk premium plays a crucial role in investment decisions, as it helps investors determine the
appropriate level of compensation for the risks they are taking. It also helps in evaluating
potential investment opportunities, asset allocation, and performance measurement.

The risk premium is directly related to the expected return and risk associated with an
investment. Higher risk investments generally require a higher risk premium to attract
investors, as they compensate for the increased potential for loss.

Types of Risk Premiums

Equity Risk Premium
The equity risk premium is the difference between the expected return on a stock or stock
index and the risk-free rate. It represents the additional return investors expect to receive for
investing in equities rather than risk-free assets.

Credit Risk Premium

The credit risk premium is the additional return investors require for investing in bonds or
other fixed-income securities with credit risk, compared to risk-free government bonds. This
premium compensates investors for the possibility of default by the bond issuer.

Liquidity Risk Premium

The liquidity risk premium compensates investors for the risk associated with holding less
liquid assets that cannot be easily converted to cash without incurring significant costs. This
premium is higher for investments that are more difficult to sell or trade in the market.

Country Risk Premium

The country risk premium is the additional return investors expect for investing in assets from
a specific country, due to the risks associated with that country's economic, political, and
regulatory environment. This premium varies across countries and can change over time as
conditions evolve.
Factors Influencing Risk Premiums
Market Conditions and Economic Environment
Risk premiums are influenced by prevailing market conditions and the broader economic
environment. During periods of market volatility or economic uncertainty, risk premiums
may increase as investors demand higher compensation for taking on risk.

Investor Risk Tolerance

Risk premiums also reflect the collective risk tolerance of investors. When investors are
more risk-averse, they may demand higher risk premiums for holding risky assets, and vice
versa.

Time Horizon
The time horizon of an investment also impacts risk premiums. Longer-term investments
generally require higher risk premiums to compensate for the increased uncertainty over time.

Asset Class and Investment Characteristics

Different asset classes and individual investments exhibit unique risk characteristics, which
can influence their associated risk premiums.
For example, investments in emerging markets or high-growth sectors may command higher
risk premiums due to their higher levels of risk and uncertainty.

Example of Risk Premium

Let’s say that Hari wants to invest Rs.1,00,000 for the best returns he can get. He has the
option to invest in government securities like Treasury Bills that, let’s say, are offering a low
rate of return of only 2%. On the other hand, he also has the option to invest in stocks that
may give him returns of up to 15%.
In case he decides to invest in stocks, he can calculate the risk premium for taking extra risks
associated with equities. By using the formula mentioned above, Hari’s risk premium will
be:

Risk Premium = Ra – Rf
= (1,00,000 x 15/100) – (1,00,000 x 2/100) = 15,000 – 2,000 = Rs. 13,000
Hence, in this case, Hari will enjoy a Rs.13,000 risk premium if he invests in stocks rather
than investing in risk-free investments. This, however, is subject to the positive performance
of the stocks. Therefore, Hari needs to understand the risk factors associated with stocks
before going ahead with the investment.

The equity risk premium formula that is used for calculation is as follows:
Equity Risk Premium (ERP) = Expected Market Return – Risk-Free Rate

Market Risk Premium:

How To Calculate?

Let us look at some of the formulas used to calculate risk premiums in the financial market.

Specific premium forms can also be calculated separately, known as the market risk
premium formula and Risk Premium formula on a Stock using CAPM. The former
calculation aims to calculate the premium on the market, which is generally taken as a market
index like the S&P 500 or Dow Jones. It is achieved by subtracting returns on a risk-free
investment from a probable return on a similar investment in a specific market index.
Market Risk Premium = Rm – Rf

The expected risk premium formula on a stock using CAPM is intended to help understand
what other returns can be had with investment in a specific stock using the Capital Asset
Pricing Model (CAPM). The risk premium for a specific investment using CAPM is beta
times the difference between the returns on a market investment and a risk-free investment.
Expected Return = rf + Beta (rm – rf)

What Are Stock Market Index/Indices?

Stock market indices represent a certain group of shares selected based on particular criteria
like trading frequency, share size, etc. The stock market uses the sampling technique to
represent the market direction and change through an index.

To help you understand this concept further, let’s begin with the most basic question, what is
a stock market index?

Stock Market Index Meaning

A stock market index is a statistical tool that reflects the changes in the financial markets.
The indices are indicators that reflect the performance of a certain segment of the market or
the market as a whole.

A stock market index is created by selecting certain stocks of similar companies or those that
meet a set of predetermined criteria. These shares are already listed and traded on the
exchange. Share market indices can be created based on a variety of selection criteria, such as
industry, segment, or market capitalization, among others.

Each share market index measures the price movement and the performance of the shares that
constitute that index. This essentially means that the performance of any stock market index
is directly proportional to the performance of the underlying stocks that make up the index. In
simpler terms, if the prices of the stocks in an index goes up, that index, as a whole, also goes
up.

What Are The Types Of Stock Market Indices?

There are different types of stock market indices based on the kind of stocks taken into
account to create the index. Here’s a closer look at some of the most common types of
indices:

 Benchmark indices such as BSE Sensex and NSE Nifty

 Broader indices such as Nifty 50 and BSE 100
 Indices created based on the market capitalization of companies, such as BSE Midcap and
BSE Smallcap
 Sector-specific indices like Nifty FMCG, Nifty Bank Index, CNX IT, and S&P BSE Oil and Gas
A Closer Look At The Two Benchmark Indices In The Indian
Stock Market
India’s stock markets have two benchmark indices - BSE Sensex and NSE Nifty.

S&P BSE Sensex:

Sensex is a blend of the words sensitive and index. It was introduced in 1986 and is the oldest
in India. The BSE Sensex consists of the top 30 largest and most frequently traded stocks
listed in the Bombay Stock Exchange (BSE).

CNX NIFTY (NIFTY 50):

Also known as the NSE Nifty, this share market index consists of the top 50 largest and most
frequently traded stocks within the NSE. First created in 1996, NSE NIFTY is owned and
maintained by India Index Services & Products Limited (IISL), which is a joint-venture
organization between an Indian credit rating agency CRISIL and the National Stock
Exchange. The CNX portion in the CNX NIFTY stands for CRISIL and NSE.

Types of Stock Market Indices

a) Sectoral Index

Both the BSE and the NSE have some strong indicators that gauge companies in a given
sector. Indices like the S&P BSE Healthcare and NSE Pharma are known to be good
indicators of changes in the pharmaceutical sector. Another notable example is the S&P BSE
PSU and Nifty PSU Bank Indices, which are indices of all listed public sector banks.
However, neither exchange is required to have equivalent indexes for all industries, yet this is
a key cause in general.

b) Benchmark Index

The Nifty 50 index, which consists of the top 50 best-performing equities, and the BSE
Sensex index, which consists of the top 30 best-performing stocks, are indicators of the NSE
and the Bombay Stock Exchange, respectively. This group of equities is known as a
benchmark index since they employ the best standards to regulate the companies they select.
As a result, they are regarded as the most reliable source of information about how markets
work in general.
c) Market Cap Index

Few indices select companies on the basis of their market capitalization. Market
capitalization refers to the stock exchange market value of any publicly traded corporation.
Indices such as the S&P BSE and NSE small cap 50 are companies with a lower market
capitalization as defined by the Securities Exchange Board of India (SEBI).

d) Other Kinds of Indices

Several additional indices, such as the S&P BSE 500, NSE 100, and S&P BSE 100, are
slightly larger and have a greater number of stocks listed on them. You may have a low-risk
appetite, but Sensex stocks may have a high-risk appetite. Investment portfolios are not
designed to fulfil all demands. As a result, investors must remain focused and invest in areas
where they feel secure.

Formation of an Index

A stock market index is formed by combining equities with similar market capitalizations,
business sizes, or industries. The index is thereafter computed based on the stock pick.
However, each stock will have a distinct price, and the price range in one stock will not be
the same as the price range in another. As a result, the index value cannot be determined by
simply adding the prices of all the stocks.

As a result, allocating weights to stocks enters the picture. Each stock in the index is given a
certain weightage depending on its current market price or market capitalization. The weight
defines the impact of stock price fluctuations on the index value. The two most widely used
stock market indices are:

a) Market Cap Weightage

Market capitalization refers to a company's overall market value on the stock exchange. It is
computed by multiplying the total number of outstanding stocks issued by the corporation by
the stock price. However, for a market-cap-weighted index, the stocks are chosen based on
their market capitalization relative to the overall market capitalization of the index.

Assume a stock has a market capitalization of Rs. 100,000, and the underlying index has a
total market capitalization of Rs. 2,000,000.

As a result, the stock will be given a weightage of 50%. An investor should keep in mind that
the market capitalization of a company changes every day with the change in its price, and as
a result, the weightage of the stock changes daily. In India, several indices use free-float
market capitalization. The total number of shares listed by corporations is not used to
determine market capitalization in this case. Instead, they use the number of publicly traded
shares.

b) Price Weightage

The index value is calculated utilizing market capitalization rather than the company's stock
price in this technique. As a result, equities with higher prices receive more substantial
weightage in the index than stocks with lower prices.

Why Are Stock Market Indices Required?

The performance of market indices acts as a nearly accurate indicator of the state of the
markets and reflects the general sentiments of investors. These indices also provide investors
with a wealth of information that helps them create and implement investment strategies.

Provide Important Information For Benchmarking:

Many traders, investors and other market participants use the performance of the indices as a
benchmark for analyzing their investments in the stock market. For instance, you can use the
performance of NIFTY over a given period to compare it with the actual performance of the
stocks in your investment portfolio during that period.

Help Minimize Your Exposure To Risk:

One way to outperform the market is by investing in index funds. The risk of
underperformance is low in index funds because they contain stocks from several sectors and
industries, thereby essentially diversifying your investment portfolio. When you invest in
specific stocks, your corpus might be eroded if those stocks don’t perform well. With stock
market indices, however, your risk exposure is largely reduced.
Help Passive Investors:

Picking the right stocks to invest in requires a great deal of research. This may be impractical
for passive investors, who are looking for avenues to invest in over the long term without
constantly monitoring their portfolio actively.