Risk premium is the extra return demanded by investors for holding risky assets compared to risk-free alternatives like government bonds. This compensation reflects the uncertainty and potential volatility associated with different investments. Risk premiums vary by asset class, with stocks typically requiring higher premiums than bonds due to greater volatility.

Risk premium levels fluctuate with market conditions, economic uncertainty, and investor sentiment. During stable periods, risk premiums compress as investors accept lower compensation for risk, while during crises, premiums expand as risk aversion increases. Understanding risk premiums helps assess fair value and identify attractive investment opportunities.

Real-world example: If 10-year Treasury bonds yield 3% and stocks are expected to return 8%, the equity risk premium is 5%, representing the additional compensation investors demand for accepting stock market volatility and uncertainty.