Risk premium

Definition

Risk premium is the return above the risk-free rate that investors demand for taking on additional risk. It compensates investors for the potential variability in returns from a risky asset compared to a risk-free asset.

5 Must Know Facts For Your Next Test

1. Risk premium is a key component of the Capital Asset Pricing Model (CAPM).
2. It is calculated as the difference between the expected return on a market portfolio and the risk-free rate.
3. A higher risk premium indicates greater perceived risk associated with an investment.
4. The risk-free rate is typically represented by government bonds, such as U.S. Treasury bills.
5. Investors use the risk premium to decide whether an investment's potential return justifies its risk.

Review Questions

• How is the risk premium calculated?
• Why is the concept of risk premium important in investment decisions?
• What does a higher risk premium indicate about an investment?

Related terms

Capital Asset Pricing Model (CAPM): A model used to determine the appropriate required rate of return of an asset, factoring in its specific risks.

Expected Return: The anticipated return on an investment, considering both probability and magnitude of possible outcomes.

Risk-Free Rate: The theoretical rate of return on an investment with zero risk, typically represented by government bonds like U.S. Treasury bills.