What Is a Risk Premium?
Investing money in the stock market and other assets can be very risky. The risk involved can be either higher or lower, and risk premiums help to ease the worry of those who are involved in high-risk investing.
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Features
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Investments have a risk-free rate of return that they are expected to yield. A risk premium is considered to be the return that is excess of the risk-free rate.
Function
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A risk premium is a form of compensation for investors who are willing to go down the high-risk road. The risk premium does not alleviate all worry, as investors still stand to lose money on high-risk investments.
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Considerations
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A risk premium might seem unfair, as people who invest in high-risk assets know from the start what they are getting into. In reality, a risk premium is similar to hazard pay offered to those in dangerous jobs.
Benefits
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Although high-risk investments can end up in huge losses, risk premiums make it possible to make a lot of money. If an investment with a risk premium works well, its returns can be much greater than the returns from low-risk investments.
Fun Fact
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Investing helps to pump money into the economy. Risk premiums give people incentives to invest their money when they otherwise would not.
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