What is the meaning of risk premium?

The meaning of risk premium refers to the excess return that investors expect to earn from an investment above the return they would receive from a risk-free asset, such as government bonds. This concept is fundamental in finance, as it compensates investors for taking on additional risk associated with investing in securities that have the potential for higher returns but also come with greater uncertainty.

In investment theory, the risk-free rate is typically represented by the yield of government securities, which are considered nearly free from default risk. Investors expect to receive a premium for choosing riskier investments because the possibility of losing money or experiencing volatile returns is significantly greater compared to safer assets. Thus, the risk premium serves as a motivator for investors to accept additional risk in pursuit of higher potential returns.

In this context, other choices do not align with the established financial concepts. The cost of insurance against risk involves protection mechanisms rather than a return metric. The amount of money lost in high-risk investments pertains more to the outcomes of poor investment choices rather than the concept of expected returns. Lastly, the rate of return on a risk-free investment defines a baseline for comparison but does not capture the fundamental essence of what a risk premium is—the additional expected compensation for assuming risk.