Risk premium:


Definition: The additional returns expected by the investor, for inviting the risk.

It is also known as the price of risk and it is a reward to risk ratio.

Go through the following simple example.

A passenger booked an auto for going from Place - A to Place - B in a city.

As per the meter it was Rs30 and the distance between two places A and B is roughly around 2.5kms.

It was Friday and before sitting in the auto, the auto driver explained the passenger that he will be charging an additional Rs20 above meter charges.

The passenger got off the auto and while paying Rs50, he asked the auto person why you are charging Rs50, when it is only Rs30.

Auto person explained the risk management:

"Sirji, Rs30 to actual fare he.. That is for fuel. Mene ye traffic me enter honeka jo risk liya, uskeliye koun compensate karega?"

In other words:

"Sir, the fare of Rs30 is for fuel expenses. I entered into a risky position, by entering into a traffic zone. The additional Rs20 is to compensate that risk".

How beautifully, the risk premium is explained by the Auto driver!


Thanks a lot.