Risk Premium Theory

Risk Premium Theory explains that investors require extra compensation, called a risk premium, when investing in assets with uncertain returns. Because risky investments can lose value, investors demand higher potential rewards—like higher interest rates—to offset this uncertainty. Essentially, the risk premium is the additional return above the risk-free rate (such as government bonds) that incentivizes investors to take on more risk. This theory helps explain why riskier assets tend to have higher interest rates and guides investors in balancing potential rewards against possible losses.