DEFINITION of Risk Discount
A risk discount refers to a situation where an investor is willing to accept a lower expected return in exchange for lower risk or volatility. The degree to which any particular investor, whether individual or firm, is willing to trade risk for return depends on the particular risk tolerance and investment goals of that investor.
BREAKING DOWN Risk Discount
An investor who decides to take a risk discount may choose to purchase a high-grade corporate bond with a yield to maturity of 5%, instead of a lower-rated bond from another firm with a yield to maturity of 5.25%. This investor elects to sacrifice the higher return of the second bond in exchange for the safety of the first, high-rated, bond. This is referred to as the risk discount.
Risk Discount vs. Risk Premium
The risk premium refers to the minimum expected return an investor will accept to hold an investment. The risk premium is usually measured against the risk-free rate, or the amount offered by the safest available asset, such as Treasury bills. Thus, the risk premium is the investor’s willingness to accept risk in exchange for return. Those who choose to take a risk discount versus a risk premium tend to be risk-averse.
In finance, the risk premium is often measured against Treasury bills, the safest (and generally lowest-yielding) investment. The difference between the expected returns of a particular investment and the risk-free rate is called the risk premium or risk discount. That difference is usually measured on ex-post basis.
In fixed income, this difference is called the credit spread. The credit spread is the difference in expected return between two related securities.
In equities, the expected return is measured by combining dividend yields and capital returns. This expected return is not an observable quantity as it is with bonds, though it is believed to exist and is referred to as the equity premium.
Risk Premia as Return Drivers
The expected returns of various investments are driven by their varying risks. Investors expect to be compensated for the risks they take, and the sources of those risks vary. Different risk sources, sometimes called return drivers, include equity risk (volatility of price over time), duration risk (sensitivity to interest-rate changes) and credit risk (the likelihood that a borrower might default or fail to pay you back). These return drivers are called risk premia.
Investors try to minimize the overall risk in their portfolios by constructing one that generates its return from multiple, balanced, sources of risk.