What is a risk premium?

A risk premium is defined as the return over the risk-free rate of return that compensates investors for taking on additional risk associated with a particular investment. This concept is crucial in finance as it helps to determine the expected return that investors require when they decide to invest in riskier assets, such as stocks or corporate bonds, instead of safer, low-risk investments like government bonds. The risk premium reflects the uncertainty of the investment and is essential for evaluating the attractiveness of various investment opportunities.

In contrast, other options describe different financial concepts. The guaranteed return on a government bond doesn’t involve risk compensation, as government bonds are often considered free of credit risk. The interest rate charged by banks on loans pertains to lending practices rather than investing reward for risk. Lastly, profit above operational costs refers to business profitability rather than investment risk. Understanding the risk premium is vital for making informed investment decisions.