What is Risk Premium?
When we invest our hard-earned money, we all want a little something extra for taking risks, right? That “extra” is exactly what we call risk premium. It’s like a reward investors expect for putting their money into something that’s not guaranteed to be safe.
Imagine this — you could keep your cash in a savings account with very little risk, or you could invest in a new startup that might make millions, or might go bust. That extra return you’d want (or need) to take the chance on the startup instead of playing it safe? Yep, that’s the risk premium.
In simple words, risk premium is the return over and above the “risk-free” rate — usually based on government bonds — that investors demand for taking on more uncertain investments.
Now here’s the thing: different types of investments come with different levels of risk, so the risk premium varies too. Stocks usually have a higher risk premium than bonds, because they’re more volatile. Junk bonds have even higher risk premiums, since they carry the chance of default.
Some folks get it confused with interest rates or inflation, but nah — it’s more about investor psychology and the “what if” factor.
If you think about it, it kind of reflects how much trust (or fear) people have in the market or a specific investment at any moment. When things feel shaky, investors will demand higher risk premiums to jump in. And when things look stable, they’re a bit more chill with smaller premiums.
TL/DR:
Risk premium = reward for taking risk.
No risk, no premium. High risk, high reward (sometimes).