Types of Risk Premium

It is commonly accepted that when an individual takes on risks in investing he expects a financial return. Each time a new layer, or type, of risk is added to an investment decision it is said that a risk premium is paid to the investor for taking on the additional risk above and beyond "the risk free rate" (typically U.S. Treasury bonds). A measurable, additional financial gain must exist for investors taking on risk otherwise no one would invest in risky assets. That measurable additional financial gain is referred to as risk premium.

Credit risk premium is the premium paid to investors for investing in bonds other than U.S. Treasury bonds. U.S. Treasury bonds are considered risk free and pay a low rate of interest. Any bond is riskier than a treasury bond and the riskier it is the more interest it pays.

Sovereign risk is created when the political climate in a country makes investing riskier. An investor in a country with a record of civil unrest and who is therefore worried about political instability will expect a higher rate of return than if he invests in politically stable countries such as the United States, Canada and Britain.

When an investor buys a public stock it is said that he takes on equity risk premium. This refers to the fact that the investor could have purchased a bond, which is considered less risky, instead of the stock. Since the stock is riskier, it of course, must return greater financial gains to the investor than the bond would.