Risk Premium refers to the additional return an investor expects to earn from a risky investment compared to a risk-free asset. It represents the compensation investors demand for taking on higher uncertainty in their investment decisions. In simple terms, it’s the reward for bearing risk in the financial markets.

At its core, the risk premium is calculated as the difference between the expected return on a risky asset and the return on a risk-free investment, such as government securities. For example, if a stock is expected to return 12% and a government bond yields 6%, the risk premium is 6%. This concept helps investors assess whether the potential reward justifies the risk undertaken.

There are different types of risk premiums based on asset classes and market conditions — such as equity risk premium, bond risk premium, and market risk premium. The size of the premium often reflects investor sentiment, economic stability, and market volatility. In times of economic uncertainty, investors typically demand a higher premium for riskier assets.

Understanding the risk premium is crucial for portfolio management and asset valuation. It forms a key component of models like the Capital Asset Pricing Model (CAPM), which links risk and expected return to help investors make informed decisions. A higher risk premium indicates greater perceived risk, while a lower premium suggests market confidence and stability.

In essence, the risk premium serves as a guiding metric for balancing risk and return. Investors can use it to align their investment choices with their risk tolerance and long-term financial goals, ensuring a more rational and data-driven approach to wealth creation.