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Risk Premium

Trading Term

In the context of hedging, a risk premium is the amount a risk-averse party is willing to pay above actuarially fair value in order to transfer downside risk to someone else. In a binary contract market this would appear as YES prices on adverse events being bid above the true probability of those events, which correspondingly leaves the NO side available below its fair value and creates the compensation that draws in counterparties. Whether such a premium is present and persistent in any given market is an empirical question that depends on the balance between hedgers seeking protection and investors willing to supply it.

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