What are risk premiums?

Risk premiums refer to the additional return that investors require for taking on the risk of an investment compared to a risk-free asset, such as government bonds. It is essentially a reward for embracing uncertainty and potential fluctuations in returns. In the context of investing, the risk-free rate is often represented by the yield on government securities, which are considered low-risk. The risk premium is the difference between the expected return on a risky asset (like stocks) and the risk-free rate; it compensates investors for the possibility of losing part of their investment or not achieving the expected returns.

This concept is crucial for understanding investment decisions, as it reflects the relationship between risk and potential reward. Investors seek higher returns from riskier investments, and the risk premium acts as an incentive for them to engage in those investments despite the inherent uncertainty.