Risk Premium

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What is a 'Risk Premium'

A risk premium is the return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.

BREAKING DOWN 'Risk Premium'

Think of a risk premium as a form of hazard pay for your investments. Just as employees who work relatively dangerous jobs receive hazard pay as compensation for the risks they undertake, risky investments must provide an investor with the potential for larger returns to warrant the risks of the investment.

For example, high-quality corporate bonds issued by established corporations earning large profits have very little risk of default. Therefore, such bonds will pay a lower interest rate (or yield) than bonds issued by less-established companies with uncertain profitability and relatively higher default risk.

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RELATED FAQS
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    Take a look at historical equity risk premium and credit spreads in the United States, which suggest that equities carry ... Read Answer >>
  2. What is the correlation between equity risk premium and risk?

    Learn about the relationship between the risk-free rate of return and the equity risk premium, and understand how the risk-free ... Read Answer >>
  3. Is market risk premium the same for all investors and investments?

    Learn about how market risk premiums are determined, how they are calculated, why some assets require higher premiums and ... Read Answer >>
  4. How is the risk-free rate of interest used to calculate other types of interest rates ...

    Learn how the risk-free rate is used to compare the yields on bonds, and understand how T-bills are used as a proxy for the ... Read Answer >>
  5. What is the historical market risk premium?

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  6. How accurate is the equity risk premium in evaluating a stock?

    Learn about the drawbacks of using the equity risk premium to evaluate a stock, and understand how it is calculated using ... Read Answer >>
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