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A risk premium, or the borrowing cost of money, is the extra price that a country pays to obtain finances from the market compared to other countries. This added percentage is used as a reference point. The higher a country’s risk (that is doesn’t pay its debts, also called a default), the higher the risk premium will be and, therefore, the interest rate paid to investors that the country would have to pay when servicing its national debt.

A risk premium is also the profitability in terms of interest that investors demand from a country when buying their sovereign debt in comparison to other countries. The risk premium measures the confidence that investors have in a country, which is to say if they think the country’s economy is sound and stable while considering what interest they would like to receive on their investment when faced with the perceived risk. In short, the term ‘risk premium’ is used by investors to calculate what they would like to receive back on their investment and the term ‘borrowing cost’ is used by governments to show what interest rate they will have to pay on their sovereign debt that investors choose to buy. They are basically two terms for the same idea but differ since the usage depends on who (investor) or what (government) you are. This economic term shows the excess yield that investors desire as the risk level increases. This goes along with the economic law that says at greater risk levels, yields also need to be greater to assure that people want to invest in a certain type of financial product (in this case, typically bonds). So when an investor accepts a certain risk level, they expect to be compensated. The risk premium is calculated by subtracting the yield of a risk free investment from the expected yield from a risky investment with the same maturity date. For the european union (EU-27) and, in particular, the eurozone (EU-17), the risk premium comes from the difference that exists between the interest rate that any given country pays for investing in one of its national bonds and the interest rate or type of debt with the least probability of default (the base reference point). This difference is called a credit spread. The base reference point in the EU-17 today is the debt issued (bonds) by the German treasury called ‘Bunds’.