Risk – Return trade off function or Indifference curve R indicates that the manager or investor is indifferent among 7.5% rate of return with Risk = 0; 10% return on an investment with Risk = 3.5 (Pt.B), 14% return on an investment with Risk = 6 (Point C) and 18% Return on an investment with Risk = P (Point)
Thus Risk Premium at Point ‘B’ is 2.5% (10 -7.5) Risk Premium at Point ‘C’ is 6.5% (14-7.5%) and at Point D is (18-7.5) 10.5% A more risk averse manager or Investor (Curve R′ ) requires a higher premium while a less risk averse one (with Curve R”) requires a smaller Risk Premium for each level of Risk.
The higher the Risk, the higher the return. If an investor invests Rs.100 in the Bank in F.D. he will get Rs.110 after one year (Assuming interest rote to be 10%). But if he invests in the stock market Rs.100, he may get Rs.200 after one year (higher returns) but he may totally loose his principal amount even.