Final answer:
A risk premium is the extra return an investor demands to compensate for the additional risk of an investment compared to a risk-free asset. In the given example, the bond price is reduced below face value to align its yield with that of riskier bonds in the market, due to changes in interest rates.
Step-by-step explanation:
The risk premium is the additional return over the risk-free rate that an investor requires as compensation for the risk of an investment. In the context of the bond example provided, if the market interest rate has risen to 12%, the 8% bond appears less attractive in comparison, as investors can find bonds with higher rates due to increased prevailing interest rates. Therefore, to sell the 8% bond, its price would be lowered below the face value to offer a comparable yield to the current market rate, essentially accounting for the opportunity cost and additional risk associated with this bond investment over others.