What is meant by risk premium?

Risk premium refers to the additional return that investors require for taking on the risk associated with a particular investment compared to a risk-free asset. Investors generally expect to be compensated for assuming the uncertainty and potential for loss that comes with investing in assets that have higher risk, such as stocks or corporate bonds. This extra return is essentially a reward for bearing that risk, and it reflects the idea that riskier investments should offer the possibility of greater returns to attract investors.

In contrast, government bonds are often perceived as safer and typically offer lower returns due to their lower risk, which would not characterize a risk premium. Similarly, the concept of a risk premium does not apply to safe assets that guarantee a return, as they do not require any additional compensation for taking on risk. The idea of a standard return from any investment does not account for the variability and risk associated with different types of investments. Therefore, the correct answer is that the risk premium represents the additional return required for taking on higher risk.