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For the period 1926-2011, small-company stocks had a risk premium of 12.6 percent. What does the...

For the period 1926-2011, small-company stocks had a risk premium of 12.6 percent. What does the term risk premium mean? Is the risk premium on these stocks considered to be relatively high or relative low as compared to other investment classes? Explain why.

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Answer #1

Risk premium is the reward for the risk taken by investing in a particular security. It is the reward one should receive over and above the risk free rate. So the 12.6% is the compensation, over and above the risk free rate, that investors were demanding for investing in small company stocks.

The risk premium on the small companies was the highest among all alternatives during that period. Those stocks have also returned higher returns with greater volatility.

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