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Risk Premium

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In finance, the risk premium is the additional return received or expected in exchange for the perceived risk of an investment above the risk-free interest rate. Even though the risk-free rate is a theoretical concept that can only be estimated, since it is a constant, the risk premium of two alternative investments can still be compared. Modern portfolio theory links the risk premium to the expected return on an investment in a number of models such as CAPM, or the Capital Asset Pricing Model. In debt markets, the risk premium is known as the credit spread. In equity markets, the risk premium is the total return from both dividends and appreciation, less the risk-rate. This equity risk premium is often called simply an equity premium. Whatever the risk premium, the rate of return going forwards is an expected rate of return. The higher the risk premium, the greater the uncertainty of actual return.



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