What defines a risk premium?

A risk premium is fundamentally characterized as the extra return that investors demand for taking on additional risk compared to a risk-free investment, typically represented by government bonds or treasury securities. The rationale behind this is that in order for investors to feel justified in holding securities that hold more uncertainty—such as stocks or corporate bonds—they require a higher return to compensate for the risk of potential losses.

This premium acts as an incentive for investors to allocate their resources towards riskier assets instead of safer alternatives. It reflects the disparity in expected returns between a risky asset and a risk-free asset. When considering the fundamental principles of finance, the concept of the risk premium is central to asset pricing models, such as the Capital Asset Pricing Model (CAPM), which quantifies the expected return of an investment as a function of its risk relative to the risk-free rate.

The other options do not accurately capture the essence of a risk premium. The first option refers to long-term assets in a general sense but does not specifically address the requirement of extra return for bearing risk. The third option speaks about transaction costs, which are separate from the concept of risk premium. The fourth option mentions the average return of the stock market, which is more about market performance rather than the additional compensation for