The Key Difference Between Risk-Free Rate vs Risk Premium

risk-free rate vs risk premium
Feature	Risk-Free Rate	Risk Premium
Definition	The return on an investment with zero risk, typically from government securities.	The additional return expected for taking on higher risk over the risk-free rate.
Purpose	Serves as a baseline for measuring other investment returns.	Compensates investors for the risk of investing in uncertain assets.
Examples	Returns from U.S. Treasury bills or government bonds.	Extra return expected from stocks, corporate bonds, or emerging markets.
Risk Level	No risk of default or loss.	Reflects the level of risk an investor takes on.
Calculation	Usually derived from yields on sovereign debt (e.g., 10-year treasury).	Calculated as Expected Return - Risk-Free Rate.
Investor View	Safe haven for capital preservation.	Used to evaluate whether the potential return justifies the risk.
Influence on Valuation	Used as a base in models like CAPM and DCF.	Determines the discount rate and expected return above risk-free assets.
Stability	Generally stable and influenced by central bank policy.	Varies by asset type, market conditions, and economic outlook.
Importance	Essential for benchmarking and pricing financial instruments.	Crucial for assessing investment attractiveness and required returns.