Risk Premium

Investors generally prefer certainty. To persuade them to accept risk, riskier investments must offer the prospect of higher returns. The difference between the expected return of a risky investment and the return on a risk-free asset is the risk premium.

For example, if a government bond yields 4% and a corporate bond of the same maturity yields 6%, the corporate bond offers a risk premium of 2 percentage points to compensate for the chance that the company might default.

Risk premiums exist across many types of investment. The equity risk premium is the extra return expected from shares over safe government bonds. The credit spread is the risk premium on corporate debt. There are also premiums for illiquidity, for investing in smaller companies and for investing in riskier countries.

Risk premiums change over time. When investors are nervous, during recessions or crises, they demand larger premiums, which pushes up yields on risky assets and lowers their prices. When investors are confident, premiums shrink.

Risk premiums are expectations, not guarantees. A risky investment can still lose money, even if it offered a high premium.