What Is a Risk Discount?
A risk discount refers to a situation in which 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 an individual or firm, is willing to trade risk for return depends on the particular risk tolerance and investment goals of that investor.
- Risk discount refers to a situation in which an investor accepts lower expected returns in exchange for lower risk.
- A risk premium is the risk taken above the risk-free rate with the expectation of higher returns.
- The difference between the expected returns of a particular investment and the risk-free rate is called the risk premium or the risk discount depending on if the returns are higher or lower.
- Risks that drive higher returns and some investors towards risk discounts include equity risk, duration risk, and credit risk.
- Investors choose investments with either risk premiums or risk discounts based on their risk tolerance.
Understanding a Risk Discount
The risk premium refers to the minimum expected return an investor will accept to hold an investment whose risk is above 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.
For example, 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 5.5%. The 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 Premium vs. Risk Discount
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, depending on if the investor chooses an investment whose expected return is above or below the risk-free rate.
In fixed income, the difference between a Treasury bond and another debt instrument of the same maturity but different quality is known as the credit spread.
For stocks, 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.
In general, a stock would not have a risk discount because it is uncertain which direction the stock's price will move over a certain period of time. Its price depends on a multitude of factors so it would be difficult for an investor to gauge their return. Stocks are riskier than bonds or investments with risk-free rates.
One of the safest assets is the U.S. Treasury bill. Because they are low risk, T-bills offer a low rate of return.
Risk Premiums 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).
Investors try to minimize the overall risk in their portfolio by constructing one that generates its return from multiple, balanced, sources of risk. Those investors who have the capacity to take on more risk will opt for investments that provide higher returns, whereas those investors who cannot take on significant risks, will opt for investments with a risk discount.
The risk discount does not account for the length of time money must be locked up in an investment.
Examples of Risk Discounts
For example, a billionaire may invest $500,000 in an oil pipeline in a war-torn country where, if successful, would reap millions of dollars in returns. However, if unsuccessful, the billionaire would lose the entire $500,000, without much damage to their other finances.
On the other hand, a single mother of two children that works as a waitress might invest $50 a month into a certificate of deposit (CD) with a return of 0.7% annually, as opposed to investing $100 in a corporate bond of a mediocre company expected to return 8% annually. The mother will opt for the safer, lower-yielding investment, whereas the billionaire is comfortable with a risky, possibly high yielding investment.
A risk discount does not take into account the time value of money, or the length of time that an investment will be locked up. This is expressed by the risk adjusted discount rate, a metric that measures the value of future payoffs in present-day dollars. Put briefly, the risk adjusted discount rate places greater discount on long-term investments than on shorter ones, and a greater discount on low-risk investments than on risky ones.
For example, a long-term certificate of deposit needs to pay a higher interest rate than shorter-term CDs, because of the length of time that the depositor's funds are unavailable. Likewise, investors require lower interest rates from highly-rated corporate bonds than they expect from junk bonds. The risk-adjusted discount rate accounts for both the length and risk of an investment.
What Is Risk Tolerance?
Risk tolerance refers to an investor or company's willingness to undertake high-risk ventures for the chance to earn higher profits. Certain industries, such as venture capital, have extremely high rates of failure, although in rare cases their investments may prove extremely profitable. Conversely, many banks will only lend money to highly predictable business ventures, and their returns are comparatively low as a result.
How Do You Find the Risk Discount Rate?
The risk discount rate is the difference between an investment's return and the risk-free rate of return. If an investment has a lower return than the risk-free rate, this difference is referred to as the risk discount; otherwise, it is called the risk premium.
How Do You Calculate the Risk Premium?
The risk premium is the additional return of an investment, in excess of the returns on an investment with no risk. This is usually calculated by subtracting the investment's returns from the interest rate of an extremely low-risk asset, like the U.S. treasury bond. For example, if an investment pays 2% interest and a treasury pays 0.5% interest, the risk premium on that investment is 1.5%.
How Do I Reduce Risk in My Portfolio?
One of the simplest ways to reduce risk is through diversification, spreading out a portfolio among many different companies and types of assets. Since it is extremely unlikely that all of these assets will fail, a well-diversified portfolio will have fewer severe risks than a highly concentrated one.