Final answer:
The risk premium is the additional return investors expect for taking on the risk of an investment. A lower risk premium indicates lower perceived risk, while a higher risk premium indicates higher perceived risk.
Step-by-step explanation:
The risk premium is the additional return an investor expects to receive for taking on the risk of a particular investment compared to a risk-free investment, such as a government bond. A lower risk premium means that investors are demanding less compensation for taking on risk, indicating that they perceive the investment to have lower risk. Conversely, a higher risk premium suggests that investors are demanding more compensation for the higher risk associated with the investment.
For example, suppose there are two investment options: Option A has a 5% expected rate of return and a low level of risk, resulting in a risk premium of 2%. Option B has a 10% expected rate of return and a high level of risk, resulting in a risk premium of 6%. In this case, Option B has a higher risk premium because investors require a greater return to compensate for the higher risk.