What does the term 'risk premium' refer to?

The term 'risk premium' specifically refers to the additional return that investors require to bear the risk associated with an investment compared to a risk-free asset. This concept is grounded in the relationship between risk and return—investors expect to be compensated for taking on more risk. For instance, since government bonds are generally considered low-risk investments, the return on these bonds serves as a benchmark. Any higher return demanded for investments that carry greater risk, such as stocks or corporate bonds, constitutes the risk premium.

In this context, the risk premium reflects the trade-off inherent in investing: the greater the uncertainty of an investment's return, the higher the potential reward investors expect in order to justify taking on that risk. This measure is critical for making informed investment decisions, as it provides insight into the relationship between risk tolerance and expected return.