Risk premium is the minimum incremental yield by which the expected return on a risky asset must exceed the known return on a risk-free asset in order to induce an individual to hold the risky asset rather than the risk-free asset. The risk-free asset is typically thought of as a U.S. Treasury security with a maturity equal to the expected investment period. U.S. Treasuries produce a known return and, especially short-term Treasuries, are considered to have minimal risk.
As an example calculation, If an investor knows she can receive 3.0% on a government bond and a speculative investment is expected to return 8.0%, then the risk premium is 5.0%. The investor must then decide if the 5.0% “excess return” is enough to justify the increased level of risk. See Risk Adjusted Returns.
