Define Risk Aversion and Risk Premiums?

3 Answers

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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"Risk aversion" refers to a phenomenon whereby people try to avoid financial risk.  This is manifested by a reluctance to take a high risk opportunity with a potentially high payoff.  Risk averse people will instead opt for a low risk, low reward opportunity.

Because risk aversion exists, businesses that wish to engage in high risk behavior have to pay a "risk premium" in order to attract investors.  Technically, the risk premium is the extra amount of return (over that of a risk-free investment) that the high-risk investment must pay to attract investors.

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vinson | Teacher | (Level 2) eNoter

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If this were the entire market, the risk premium would be a weighted average of the risk premiums demanded by each and every investor.

The weights will be determined by the wealth that each investor brings to the market. Thus, Warren Buffett’s risk aversion counts more towards determining the “equilibrium” premium than yours’ and mine.

As investors become more risk averse, you would expect the “equilibrium” premium to increase.