What does "risk premia" refer to in the context of capital markets?

• A. Rewards for illiquidity and complexity
• B. Guaranteed returns from safe investments
• C. Lower taxes on capital gains
• D. Minimum returns required for cash holdings

Answer: (A)

Risk premia refers to the extra return that investors demand for taking on additional risk compared to a risk-free investment. In the context of capital markets, this concept is crucial as it compensates investors for the uncertainty and potential losses associated with riskier assets.

When investors engage with assets that are illiquid or complex, they are exposed to greater risks than with more straightforward, liquid investments. Therefore, the risk premium serves as a reward for bearing those risks—essentially, it's the incentive for investors to move their capital to assets that may be less predictable and more volatile.

This understanding highlights the importance of risk into investment decisions, as well as the varied risk profiles across different asset classes. The presence of risk premia helps to explain why some investments yield higher returns than others, often aligning higher potential returns with higher risk exposure.