Explaining Risk Premium
When investing your money in more risky options, it's natural to expect better returns. This additional amount you hope to achieve compared to a safe investment is what we call the risk premium. It is simply the gap between what you hope to achieve from a risky investment and what you can achieve from a safe investment.
For example, in the United States, government treasury bonds are considered safe because the chances of the government defaulting are low. If you decide to invest in something less predictable, you want to receive a higher return for taking on that risk. The difference in potential returns between the safe bet and the riskier option is called the risk premium.
If the yield on a U.S. bond is 2%, while a corporate bond offers a yield of 5%, the risk premium is 3%. The company must offer you more because there is a real possibility of it defaulting or even going bankrupt.
The Importance of Risk Premium
The main reason investors care about the risk premium is that it helps them compare options. It is not always wise to simply pursue the highest return; you must also assess the likelihood of achieving or losing that return.
The risk premium is also important in the models used by professionals, such as the Capital Asset Pricing Model (CAPM), which helps estimate the optimal return that an investment is expected to achieve, taking into account the level of risk.
Moreover, thinking about the risk premium can encourage investors to diversify or allocate their investments. By combining assets with different risk premiums, you can attempt to balance the pursuit of higher returns while avoiding exposing yourself to unnecessary risks.
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