Did you know? Risk Premium

Risk premium refers to the additional return investors expect as compensation for taking on additional risk. In financial markets, every investment carries a degree of risk, whether it's market risk, credit risk, liquidity risk, or others. Investors require compensation for bearing these risks beyond the risk-free rate of return (traditionally, the yield on US government bonds).

The concept is grounded in the idea that higher risk investments must offer higher returns to attract investors. For instance, shares are generally riskier than bonds, given the greater uncertainties regarding the timing and amount of future cash flows. As an asset class, they typically provide higher returns over the long term. Similarly, within fixed income, poorer quality bonds — those with higher credit risk — must offer higher yields to compensate for the increased likelihood of default.

Understanding risk premia is crucial for investors when assessing the attractiveness of different investments. It helps in making informed decisions about asset allocation and balancing risk and return in a portfolio. Moreover, it underscores the fundamental principle that higher returns are generally associated with higher risks in financial markets.