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Example

Suppose a Game Show participant may choose one of two doors, one that hides $1,000 and one that hides $0. Further suppose that the host also allows the contestant to take $500 instead of choosing a door. All three options (door 1, door 2, or take $500) have the same expected value of $500, so there is no risk premium for choosing the doors over the guaranteed $500.

A contestant unconcerned about risk is indifferent to these choices. However, a Risk Averse contestant may be more likely to choose no door and accept the guaranteed $500.

If too many contestants are risk averse, the game show may encourage selection of the riskier choices (door 1 or door 2) by creating a risk premium. If the game show offers $2,000 behind the good door, increasing to $1,000 the expected value of choosing doors 1 or 2, the risk premium becomes $500 (i.e., $1,000 expected value - $500 guaranteed amount). Contestants with a Minimum Acceptable Rate Of Return of $500 or less will likely choose a door instead of accepting the guaranteed $500.


Finance

In Finance , the risk premium can be the expected rate of return above the Risk-free Interest Rate .
  • Debt: In terms of Bonds it usually refers to the Credit Spread (the difference between the bond interest rate and the risk-free rate).

  • Equity: In the Equity Market it is the returns of a company stock, a group of company stock, or all stock market company stock, minus the risk-free rate. The return from equity is the Dividend Yield and Capital Gains . The risk premium for equities is also called the Equity Premium .


The white paper Equity ''Risk Premium: Expectations Great and Small'' notes that “it is dangerous to engage in simplistic analyses of historical ERPs to generate ex ante forecasts that differ from the realized mean.” Standard & Poor’s states “the most correct method is to use an arithmetic average of historical returns.”


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