Certified Management Accountant Practice Exam 2025 - Free CMA Practice Questions and Study Guide

The risk premium represents the extra return that investors require for taking on additional risk compared to a riskless investment. In finance, this concept is critical because it highlights the relationship between risk and return; typically, higher risk investments are expected to yield higher returns to compensate investors for the increased uncertainty.

When evaluating investment opportunities, investors will assess the risk associated with a particular asset or portfolio. The risk-free rate, often represented by government bonds like U.S. Treasury bills, is considered the baseline return that carries minimal risk. The risk premium is calculated as the difference between the expected return on a risky asset and the risk-free rate, thus reflecting the compensation required by investors for bearing that risk.

In summary, the risk premium is an integral part of investment decision-making, as it influences how investors perceive the balance between risk and reward in their portfolios. This understanding allows investors to make more informed choices, as they can evaluate whether the potential return justifies the risk they are taking on.