Discount Rates vs. Risk Premiums (Differences)
While related, they serve different purposes and have distinct implications.
Understanding the differences and relationship between these two concepts is important for traders/investors, financial analysts, and anyone involved in the valuation of assets.
Key Takeaways – Discount Rates vs. Risk Premiums
- The discount rate determines the present value of future cash flows, reflecting the time value of money, while the risk premium quantifies the extra return expected for taking on additional risk.
- The discount rate is composed of the risk-free rate and the risk premium, with both having value in asset valuation and pricing.
- Economic conditions, industry specifics, and central bank policies can influence both discount rates and risk premiums, affecting trading/investment decisions and strategies.
What is a Discount Rate?
The discount rate is the rate at which future cash flows are discounted to determine their present value.
Time Value of Money
In essence, it reflects the time value of money.
A dollar received in the future is worth less than a dollar received today because of the opportunity cost associated with waiting. The discount rate compensates for this opportunity cost.
Required Rate of Return
It can be thought of as the rate of return required by an investor to invest in a particular asset or project.
For example, say an investor demands a 10% return per year.
How much would they pay for the asset in light of this?
Accordingly, they could run a discounted cash flow analysis using 10% as the discount rate.
Related: Financial Modeling Applications
What is a Risk Premium?
The risk premium is the additional return an investor requires for taking on a higher level of risk.
It’s the difference between the expected return on a risky asset and the risk-free rate.
For instance, if the risk-free rate is 2% and an investor expects a return of 8% from a stock, the risk premium is 6%.
8% is the discount rate, while 6% is the residual – i.e., the excess return for investing in that versus a different asset.
Risk premiums vary across different asset classes and individual securities, reflecting their inherent risks.
For example, it’s widely understood that the return on bonds must exceed the returns on cash, and the return on stocks must excess the return on bonds, and by the appropriate risk premiums.
While over short periods this may not be true (e.g., inverted yield curve), over the long run it’s central to the capitalist economic system.
Relationship Between Discount Rate and Risk Premium
The discount rate is often composed of two components: the risk-free rate and the risk premium.
Discount Rate = Risk-Free Rate + Risk Premium
For example, if the risk-free rate is 3% and the risk premium for a particular investment is 4%, the discount rate would be 7%.
This relationship highlights how the discount rate inherently accounts for the risk associated with an investment.
We can also make the following assertions:
- Rising Risk Premium: A rising risk premium leads to a rising discount rate, holding the risk-free rate constant.
- Falling Risk Premium: A decrease in the risk premium leads to a decrease in the discount rate, assuming the risk-free rate remains unchanged.
- Rising Risk-Free Rate: An increase in the risk-free rate results in a higher discount rate, if the risk premium remains constant.
- Falling Risk-Free Rate: A falling risk-free rate leads to a reduced discount rate, provided the risk premium remains the same.
- Both Rates Rise: If both the risk-free rate and the risk premium increase, the discount rate will rise by the sum of their increases.
- Both Rates Fall: If both the risk-free rate and the risk premium decrease, the discount rate will fall by the sum of their decreases.
- Risk-Free Rate Rises, Risk Premium Falls: If the risk-free rate increases while the risk premium decreases by the same amount, the discount rate will remain unchanged. The opposite is also true: if the risk-free rate falls while the risk premium rises by the same amount, the discount rate remains the same.
- No Change in Either: If neither the risk-free rate nor the risk premium changes, the discount rate will remain the same.
- Risk Premium Dominates: If the risk premium changes significantly while the risk-free rate changes minimally, the movement in the discount rate will be primarily driven by the risk premium.
- Risk-Free Rate Dominates: Conversely, if the risk-free rate experiences a substantial change and the risk premium has only a minor adjustment, then the primary driver of the change in the discount rate is the risk-free rate.
Importance in Valuation
Both the discount rate and the risk premium play important roles in the valuation of assets.
When valuing future cash flows, the discount rate is used to bring those cash flows to present value terms.
A higher discount rate, reflecting a higher perceived risk, will result in a lower present value.
On the other hand, the risk premium helps investors gauge the additional return they should expect for bearing additional risk.
Together, these concepts help in determining the fair value of an asset or investment.
Importance in Asset Pricing
As we described in a separate article, there are four main drivers of asset prices at the broad asset class level:
- Changes in discounted growth
- Changes in discounted inflation
- Discount rates
- Risk premiums
Understanding how these four key factors change allows for the prediction of investment asset behaviors.
Discounted growth and inflation
And all asset classes have different environmental biases as it pertains to discounted growth and inflation.
For example, stocks do best when growth is above discounted expectation and when discounted inflation is steady or falling.
Nominal rate government bonds in reserve-currency countries (i.e., no credit risk) do best in an environment of falling discounted growth and falling discounted inflation.
Balancing assets to offset their environmental biases leads to quality diversification, and can done in a way to reduce risk without compromising returns.
Discount rates and risk premiums
Discount rates and risk premiums are the other factors and impact all assets.
Generally speaking, higher discount rates and higher risk premia lead to falling assets, while the converse is true.
Factors Influencing Discount Rates and Risk Premiums
Several factors can influence the discount rate and risk premium.
For the discount rate, factors include prevailing interest rates, inflation expectations, and the overall economic environment.
For the risk premium, factors include the volatility of the asset, market conditions, and the financial health of the issuer (in the case of bonds or stocks).
Understanding these factors can help investors make informed decisions.
FAQs – Discount Rates vs. Risk Premiums
What are Discount Rates and Risk Premiums?
Discount rates and risk premiums are both financial concepts used to evaluate investments, but they serve different purposes:
- Discount Rate: This is the rate used to determine the present value of future cash flows. It represents the time value of money.
- Risk Premium: This is the additional return an investor expects to receive (or is required to receive) for holding a risky asset compared to a risk-free asset. It compensates the investor for taking on the additional risk.
How are Discount Rates and Risk Premiums related?
The discount rate is often composed of a risk-free rate plus a risk premium.
In the context of the Capital Asset Pricing Model (CAPM), the discount rate (or expected return on an investment) is calculated as:
Discount Rate = Risk-free Rate + Beta x Market Risk Premium
Here, the Market Risk Premium is the risk premium for the overall market, and Beta measures the sensitivity of the asset’s returns to the overall market returns.
Why is it important to differentiate between the two?
Differentiating between the discount rate and the risk premium is important for accurate financial modeling and investment/financial decision-making.
While the discount rate gives an overall picture of the expected return considering both risk-free returns and risks, the risk premium specifically quantifies the additional return expected for taking on extra risk.
Understanding both concepts allows market participants to make informed decisions about the risk and return trade-offs of their investments.
How do I determine the appropriate Discount Rate for an investment?
Determining the appropriate discount rate involves considering several factors:
- Risk-free Rate: Typically represented by the yield on a long-term government bond.
- Risk Premium: Based on the riskiness of the investment relative to the overall market. This can be derived using models like CAPM or by looking at historical risk premiums for similar investments (with the past not necessarily being a predictor of the future).
For certain investments, additional risk factors might need to be considered, leading to adjustments in the discount rate.
Can the Risk Premium be negative?
In theory, a negative risk premium suggests that investors are willing to accept a lower return for a riskier asset compared to a risk-free asset, which is counterintuitive.
However, in certain market conditions or due to specific external factors, observed risk premiums might temporarily appear negative.
It’s essential to analyze the underlying reasons and determine if it’s a short-term anomaly or a genuine shift in market dynamics.
Inverted yield curve
One common example is the inverted yield curve, where traders/investors may accept a lower return on longer-duration bonds relative to cash.
This is generally because they expect short-term interest rates to be cut going forward.
For example, if one can get 5% interest on cash or 4% interest on a 10-year bond, they might prefer the latter because they think the higher interest on cash will be short-lived.
Alternatively, they might think that the bond will appreciate in value as part of a tactical bet.
Or there may be a strategic purpose behind why someone would take on a negative risk premium.
Taking on longer-duration bonds can help offset risk in other parts of the portfolio, such as a falling growth environment where equities and commodities are likely to lag.
How do changes in economic conditions affect Discount Rates and Risk Premiums?
Economic conditions can significantly influence both discount rates and risk premiums.
- In a good economy, risk premiums might decrease as investors become more confident in riskier assets.
- During economic downturns or periods of high uncertainty, risk premiums can increase as investors seek higher returns to compensate for increased risks.
- Changes in central bank policies, like interest rate adjustments, can directly impact the risk-free rate component of the discount rate.
Understanding these dynamics helps investors adjust their strategies in response to changing economic landscapes.
Are there industry-specific Discount Rates and Risk Premiums?
Yes, different industries have varying levels of risk, leading to different discount rates and risk premiums.
For example, a technology startup might have a higher risk premium than an established utility company due to the inherent uncertainties in developing new technologies, changing tastes, obsolescence, and so on.
Investors and analysts often refer to industry benchmarks and historical data to determine appropriate rates and premiums for specific sectors.