equity risk premium

What is the equity risk premium?

The term equity risk premium refers to the excess return that an equity market investment provides at a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of investing in stocks. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time with changes in market risk.


An equity risk premium is an excess return obtained by an investor when he invests in the stock market at a risk-free rate.

This return compensates investors for the increased risk of investing in stocks.

The determination of an equity risk premium is theoretical because there is no way to predict the future performance of the stock or the stock market.

The calculation of an equity risk premium requires the use of historical rates of return.

How equity risk premium work

Equities are generally considered high-risk investments. Investing in the stock market involves certain risks, but it also offers the potential for significant gains. Therefore, as a general rule, investors are rewarded with higher premiums when investing in the stock market. Whatever return you earn on top of a risk-free investment like a US Treasury bill (T-bill) or a bond is called an equity risk premium.

What is a risk premium?

A risk premium is the investment return an asset is expected to produce above the risk-free rate of return. The risk premium of an asset is a form of compensation for investors. It represents the payment to investors for tolerating the additional risk of a given investment over that of a risk-free asset.

For example, high-quality bonds issued by established companies that make high profits generally have a low risk of default. Therefore, these bonds pay a lower interest rate than bonds issued by less established companies with uncertain profitability and a higher risk of default. The higher interest rates these less established companies have to pay are how investors are compensated for their higher risk tolerance.

Cost of premium

A risk premium can be costly for borrowers, especially those with questionable prospects. These borrowers must pay investors a higher risk premium in the form of higher interest rates. However, by assuming a greater financial burden, they could jeopardize their many chances of success, thus increasing the potential for default.

With this in mind, it is in investors’ interest to determine the amount of risk premium they need. Otherwise, they may find themselves fighting for debt collection in the event of insolvency. In many debt-heavy bankruptcies, investors only get pennies back on their investment, despite initial promises of a high-risk premium.

Equity risk premium

Equity risk premium (ERP) refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of buying stocks. The size of the premium varies with the risk level of a given portfolio and also changes over time as market risk changes. As a rule, high-risk investments are compensated by a higher premium. Most economists agree that the concept of the equity risk premium is valid: over the long term, markets reward investors more for taking on the most risk than for investing in equities.

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