Investors who risk more are compensated with a greater return.
Choose a section of the risk premium overview below for a full explanation.
Quick Overview of Risk premium
✔️What is risk premium?
✔️Risk and return
✔️Calculating the risk premium
The market risk premium
Average market risk premium in South Africa
What is risk premium?
The risk premium refers to the rate of return on an investment above the risk-free or guaranteed rate of return.
The risk premium is considered a form of compensation for investors for the uncertainty associated with higher risk investments.
The risk premium is applicable to securities as well as market portfolios, referred to as the market risk premium.
Risk and return
In simple terms, a trade-off refers to a situation where if one thing increases, another one must decrease.
Applying the trade-off principle to investments, investors equate low levels of risk or uncertainty with low potential returns. Conversely, high levels of risk or uncertainty are associated with high potential returns.
Put differently, the more risk involved in an investment, the higher the return an investor requires to make the investment worthwhile.
The trouble with the relationship between risk and return is that the expected return is always a potential return and never fully guaranteed.
Investors need a method to determine what their return on investment should be in order to decide and invest accordingly. This is done by calculating the risk premium.
Calculating the risk premium
To ascertain the risk premium, the risk-free rate of return and the expected return must first be calculated.
The risk-free rate of return
The risk-free rate is the rate of return on an investment when there is no possibility of financial loss or risk of default or failure. The risk-free rate of return that is currently available in the market to an investor, can be used as the benchmark in measuring the risk-free return.
Generally, the yield of a rated government bond is used as the benchmark to identify the risk-free rate of return, as it has little to no risk. For example, globally, many investors use US Treasury Bonds as a benchmark because the possibility of default is almost zero and the return is all but guaranteed. Hence, if you can earn a risk-free return of 1.5% on a US Treasury Bond, that will serve as your benchmark or baseline.
In comparison, South Africa Government Bonds, inter alia, offers yields of 4.28% (South Africa Government Bond 2Y) and 7.22% (South Africa Government Bond 5Y). (As of October 29, 2025.) These yields are considerably higher than the returns on US Treasury Bonds. However, US Treasury Bonds have excellent credit ratings, while South Africa Government Bonds have junk status ratings, which make them much riskier than US Treasury Bonds.
Finally, the choice of a benchmark for a risk-free rate is a subjective one, depending on an investor’s risk appetite.
The expected rate of return
The expected or estimated return on an investment refers to the amount of profit or loss that an investor expects from a specific investment. It is a method used by investors to determine the risk of an investment.
Bear in mind, the estimated return is a projection, not a guaranteed return. The expected return can be calculated by multiplying the potential outcomes by the percent chance of them occurring and then adding the calculations together.
Alternatively, the required rate of return for a specific security can be calculated by multiplying the security’s beta coefficient by the market coefficient, then adding back the risk-free rate.
The risk premium
This is the amount that an investor hopes to earn for allowing risk in making an investment.
The formula to calculate the risk premium reads as follows:
Risk premium = Expected rate of return – Risk-free rate of return.
Let us say, you want to compare an investment with an expected rate of return of 10% with a South Africa Government Bond 5Y with a yield of 7.22%, which is relatively risk-free. The risk premium would be 2.78% (10% – 7.22%).
If the expected rate of return is less than the risk-free rate, then the risk premium is a negative figure, implying that an investor would be better off to opt for the safer risk-free investment.
The market risk premium
The market risk premium is the average market return less the risk-free rate. It can also be described as the difference between the expected return of a risky market portfolio and the risk-free rate.
With regard to the market risk premium, there are three concepts involved in calculating the premium:
- Required market risk premium – it is also referred to as the hurdle rate or minimum acceptable rate of return (MARR). This is the minimum amount that investors are expecting on an investment.
The rate is calculated by computing the cost of capital, current opportunities in business expansion, rates of return for similar investments, and risks involved, such as economic factors present in a country, namely political stability, the inflation rate, level of a government’s debt, and trade deficits.
- Historical market risk premium – a measurement of the return’s past investment performance obtained from an investment instrument that is used to determine the premium. The return will differ depending on what investment instrument is used. The investment instrument could be the Top 40 Index of the Johannesburg Stock Exchange (JSE).
- Expected market risk premium – based on the investor’s return expectation, risk tolerance, and investing preferences.
Average market risk premium in South Africa
The average market risk premium in South Africa was 7.9% in 2025. In comparison, the market premium risk in the United States of America amounted to 5.6% in the same year.
South Africa’s average market risk premium for the past 9 years:
2019 – 8.4%
2018 – 6.9%
2017 – 7.5%
2016 – 6.3%
2015 – 7.7%
2014 – 6.3%
2013 – 6.8%
2012 – 6.5%
2011 – 6.3%
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
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