Final answer:
The risk premium is forecasted by using historical data on investment returns to gauge how much extra return is required for riskier investments. For instance, a financial investor considering a risky investment might choose a 15% interest rate to account for the risk premium in addition to the opportunity cost of capital.
Step-by-step explanation:
One method of forecasting the risk premium is to use historical data on the rate of return on other available financial investment opportunities. The risk premium is an additional return expected by investors for taking on greater risk. A financial investor decides on the appropriate interest rate to predict future payments, considering both the opportunity cost of investing capital and the added risk.
For example, if a financial investor determines a particular investment to be risky, they may add a risk premium, resulting in a higher interest rate. If they decide that 15% is the suitable rate to evaluate future payments, this reflects both the expected return on other investments and the additional risk associated with the particular investment they are analyzing.
Historically, high levels of risk have sometimes proven detrimental to investment portfolios, as reflected in financial crises or market downturns where high-risk investments suffered significant losses. Understanding risk and appropriately pricing it into investment decisions through the risk premium is hence a critical skill for financial investors.