Suppose you were faced with two equally likely outcomes.
If the first outcome occurs, you receive INR 100/-
If the second outcome occurs, you receive INR 200/-.
From eliminatory statistics, you know that the expected outcome is INR 100 * (0.5) + INR 200*(0.5) = INR 150/- which is the amount you would expect to receive on an average after playing many times. How much would you be willing to pay to take this risk?
If you say INR 150/- you are not recognizing the risk inherent in the situation you are simply saying that a fair trade would be for you to give up INR150/- for the chance to make INR 150/- on average.
You would be described as risk neutral,meaning that you are indifferent to the risk. Most individuals, however, would not find this a fair trade. They recognize that the INR 150/- you pay is given up for certain, while the INR 150/- you expect to receive is earned only on average. In fact, if you play twice, lose INR 150/- once and then gain it back, you will feel worse than if you had not played.
Thus, we say that most individuals have risk aversion. They would pay less them INR 150/- to take this risk. How much less depends on how risk averse they are.
People differ in their degrees of risk aversion. But let us say you would pay INR 125/-. Then the difference between INR 150 and 125 is considered the risk premium. This is the additional return you expect to earn to justify taking the risk.
Although most individuals are indeed risk averse, it may surprise you to find that in the world of derivative market, we can actually pretend that most people are risk neutral. No, we are not making some heroic, but unrealistic assumption. It turns out that we obtain the same results in a world of risk aversion as we do in a world of risk neutrality.
Although this is a useful point in understanding derivative markets, we shall not explore it in much depth.