What is a 'Risk Premium'
A risk premium is the return in excess of the riskfree rate of return 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 riskfree asset, in a given investment. For example, highquality corporate bonds issued by established corporations earning large profits have very little risk of default. Therefore, such bonds pay a lower interest rate, or yield, than bonds issued by lessestablished companies with uncertain profitability and relatively higher default risk.
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.Risk Compensation
Investors expect to be properly compensated for the amount of risk they undertake in the form of a risk premium, or additional returns above the rate of return on a riskfree investment such as U.S. governmentissued securities. In other words, investors risk losing their money because of the uncertainty of a potential investment failure on the part of the borrower in exchange for receiving extra returns as a reward if the investment turns out to be profitable. Therefore, the prospect of earning a risk premium does not mean investors can actually get it because it is possible the borrower may default absent a successful investment outcome.
Earnings Reward
A risk premium can be a true earnings reward as some risky investments are inherently more profitable when and if they come through as an investment success. Investments with certainties and predictable outcomes are not likely to become business breakthroughs when already operating in wellpenetrated markets. Only novel and risky business and investment initiatives could potentially offer aboveaverage returns the borrower may then use as an earnings reward for investors. This is one underlying incentive that has encouraged some investors to seek riskier investments, knowing there could be potentially bigger payoffs.
Premium Cost
A risk premium can be costly for borrowers, especially when their investments are not potentially the most prosperous ones. The more risk premium they pay investors as risk compensation, the more financial burden they may take on, which likely hurts the very success of their investments and increases the chance of a default. With this perspective in mind, it is in the best interest of investors themselves to reconsider the level of risk premium they demand, or else they must be prepared to fight over debt collections in the event of a default. In many borrowingladen bankruptcies, for example, investors only get cents on the dollar, despite prior promises of a risk premium.

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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 >> 
Is the market risk premium the same for stocks and bonds?
Take a look at historical equity risk premium and credit spreads in the United States, which suggest that equities carry ... Read Answer >> 
What is the historical market risk premium?
Learn what the historical market risk premium is and the different figures that result from an analyst's choice of calculations ... Read Answer >> 
What does a high equity risk premium signify about a company's stock future?
Learn about how a high equity risk premium affects a stock's future. These types of stocks tend to be the most volatile instruments ... Read Answer >> 
How is the expected market return determined when calculating market risk premium?
Find out how the expected market return rate is determined when calculating market risk premium and how these figures are ... Read Answer >> 
What is the correlation between equity risk premium and risk?
Learn about the relationship between the riskfree rate of return and the equity risk premium, and understand how the riskfree ... Read Answer >>