Definition Risk Premium

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 guaranteed $500.

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).

 
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