Risk Premium - A risk premium is the minimum difference
a person requires to be willing to take an uncertain
bet, between the expected value of the bet and the
certain value that he is indifferent to.
Suppose a game show participant may choose one
of two doors, one that hides $1,000 and one that
hides $0. Further suppose that the host also allows
the contestant to take $500 instead of choosing
a door. All three options (door 1, door 2, or take
$500) have the same expected value of $500, so there
is no risk premium for choosing the doors over the
A contestant unconcerned about risk is indifferent
to these choices. However, a risk averse contestant
may be more likely to choose no door and accept
the guaranteed $500.
If too many contestants are risk averse, the game
show may encourage selection of the riskier choices
(door 1 or door 2) by creating a risk premium. If
the game show offers $2,000 behind the good door,
increasing to $1,000 the expected value of choosing
doors 1 or 2, the risk premium becomes $500 (i.e.,
$1,000 expected value - $500 guaranteed amount).