Investors use portfolio risk premium as a method of assessing the value of their investments. A portfolio refers to the collection of securities owned by an investor. Portfolio risk premium refers to the money earned on an investment in exchange for the higher risk associated with the investment. Treasury bills represent the safest investment option with minimal risk. All other investments carry some degree of risk. Equity securities represent a higher risk than debt securities. Debt securities carry a legal obligation for issuers to repay them. Equity securities hold no obligation for the holder to receive any payments. Investors calculate the portfolio risk premium as they evaluate whether to keep their current portfolio, to purchase additional securities or to sell some of their current securities.
1. Identify the securities held in your portfolio. Add up the total dollar value of the portfolio.
2. Estimate the life of your portfolio. For equity securities, consider the length of time you expect to own the security. For debt securities, consider the remaining term of the security. Calculate the average life by adding these time frames together and dividing by the total number of securities.
3. Estimate the rate of return you expect from each equity security. Multiply each return by the total dollar value of the security. This equals the sum of the equity returns.
4. Identify the interest rate associated with each bond security. Multiply each interest rate by the total dollar value of the security. This equals the sum of the debt returns.
5. Add the sum of the equity returns and the sum of the debt returns. Divide by the total dollar value of the portfolio. This calculates the return you expect to receive from your portfolio.
6. Look up the interest rate on a Treasury bill that matches the average time frame of your portfolio. Subtract the interest rate on the Treasury bill from the return you expect to receive on your portfolio. This equals your portfolio risk premium.
- As you consider changes to your portfolio, start by calculating the portfolio risk premium of your current securities. Then calculate the portfolio risk premium of your securities if you made the changes. Compare the risk premium and decide whether or not to make the changes.
- Recognize that your rate of return on equity securities relies on estimates. Actual performance may not reflect the same values you estimated.
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