A risk premium is

Question

A risk premium is

BlackTom AI · Accepted Answer

Topic: definition of a risk premium in expected utility and decision theory. 
Option 1: 'a payment to an insurer by a policy-holder who faces a potential loss.' This describes a premium in the context of insurance contracts, where the policyholder pays the insurer to transfer risk, not the risk premium that adjusts choices between riskier and safer options. So this is not the technical concept of a risk premium as used in decision-making under risk. 
Option 2: 'equal to the purchase price of an insurance policy.' This option equates a risk premium with the insurance premium, which is incorrect. The insurance premium is a price paid to transfer risk to an insurer, while the risk premium is a measure of extra expected value a decision-maker requires to accept risk, not a price paid for risk transfer. 
Option 3: 'the necessary difference between the expected value of a lottery and the payoff of a sure thing to make the decision maker indifferent between the lottery and the sure thing.' This correctly captures the idea of a risk premium as the amount by which the expected value of a risky option must be adjusted (often via a premium or compensation) so that the decision-maker is indifferent between taking the lottery and accepting a certain payout. This aligns with standard definitions in decision theory and risk assessment. 
Option 4: 'the difference between the expected value and the variance of a lottery.' This mixes two distinct statistical ideas: expected value (mean outcome) and variance (a measure of dispersion). The difference between EV and variance is not a recognized concept called a risk premium, and it does not represent the premium required to be indifferent between lottery and sure outcome. 
In summary, each option presents a distinct interpretation: insurance pricing vs. risk transfer pricing vs. a formal indifference-based premium vs. a purely statistical difference. The third option aligns with the conventional definition of a risk premium in the context of choosing between a risky lottery and a certain payoff, whereas the other options describe related but not equivalent concepts.

ECON_104B_001_25S Chapter 15 Practice Problems -- Multiple-Choice

A risk premium is

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