Risk Premium: Meaning and Example

A risk premium is the extra expected return investors demand for holding a risky asset instead of a safer alternative. It represents compensation for uncertainty, volatility, default risk, illiquidity, or other forms of exposure.

How It Works

Risk premiums matter because valuation depends on the return investors require. If perceived risk rises, the premium rises too, which can lower present values and market prices. If risk perceptions ease, the premium can compress and valuations can rise.

Worked Example

If investors require 8% from an asset while the relevant risk-free return is 3%, the implied risk premium is 5%.

Scenario Question

A student says, “A higher historical return automatically proves the asset had a higher justified risk premium.”

Answer: Not always. Realized returns can differ from the premium investors expected when they priced the asset.

Related Terms

• Risk-Free Asset: Risk premiums are measured relative to safer benchmark assets.
• Equity Risk Premium: The equity risk premium is one specific form of risk premium.
• Risk-Return Tradeoff: Risk premium is a key expression of the broader tradeoff between risk and expected return.