Equity Risk Premium

Calcifies the extra return possible from stock market investments over risk-free investments

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Last Updated:March 3, 2024

What Is Equity Risk Premium?

The equity risk premium (ERP) calcifies the extra return possible from stock market investments over risk-free investments (like U.S. government bonds which carry zero risk). 

Investors receive compensation from this extra return for accepting the comparatively higher risk of equities investment. In other words, The ERP is equal to equity returns minus returns from government bonds with comparable time horizons.

The premium is calculated using a variety of qualitative and quantitative parameters, knowing that its size fluctuates and is influenced by the level of risk in a given portfolio. Additionally, it evolves with time as market risk changes. 

ERP refers to the notion that for an investment to stay effective, the risk involved with the investment must be followed by an increase in the potential reward from the venture.

The ERP is an important factor in asset allocation. Gaurav Doshi, Principal Officer, IIFL Wealth Portfolio Managers, said, “The higher the equity risk premium, the more likely investors are to tilt their portfolio in favor of equities (away from bonds).

The country risk premium is a related term that refers to when the premium is calculated for each country while considering the variations in risk for each nation.

When it is challenging to explain why investor risk aversion would result in returns on stocks generally being much greater than Treasury bonds, the equity premium is viewed as a puzzle. The equity premium puzzle attempts to explain and observe the complexity of this gap.

Key Takeaways

  • The equity risk premium (ERP) quantifies the additional return potential from investing in the stock market compared to risk-free investments like U.S. government bonds.
  • Investors receive the ERP as compensation for accepting the higher risk associated with equity investments.
  • The ERP is calculated by subtracting the returns from risk-free government bonds from equity returns with comparable time horizons. It fluctuates based on various qualitative and quantitative factors and evolves over time with changes in market risk.
  • This term refers to the calculation of the premium for each country, taking into account variations in risk across different nations.

Understanding Equity Risk Premium

The projected return for taking on greater risk is one of the most crucial figures in investing. No rational investor will take on more risk without anticipating a better rate of return, whether the risk is determined by volatility or by the potential loss of cash. 

The amount and timing of any dividend payments or other distributions, as well as the price at which a shareholder can sell equity, are all speculative. The stock investor seeks a greater return on their investment in exchange for these uncertainties. The ERP was necessary for this.

The major factor influencing investment outcomes is the investor's allocation between assets with lower risk and higher return and those with higher risk and lower return.

As the market swings over time, the risk premium changes. It is influenced by the level of risk taken on the specific portfolio, and the bigger the risk in the investment, the larger the premium.

The ERP, or additional return anticipated for investing in riskier equities instead of safer securities, is the most fundamental investment risk premium that investors consider.

The return of the overall equities market is typically subtracted from the return of US government securities, such as 90-day T-Bills or 10-Year Treasury bonds.

It is impossible to predict how well shares or the equity market will do in the future; therefore, calculating the premium is purely speculative.

What Is a Risk Premium?

There is always a danger, or risk, that the asset you invest in can perform poorly and consequently cause you to lose money.

Risk can take many different forms, including reputational, physical, and financial risks. All of these risks can be subject to the idea of risk premium, and if the risk premium can be measured, the return from each risk can be estimated.

When you invest in risky assets like stocks, you accept the possibility of losing money. A risk premium is useful in this situation: riskier investments have the potential for rewards that entice investors.

Treasury bills and bonds are types of government securities issued by the United States government and are regarded as risk-free investments.

Similarly to this, foreign government bonds may be seen as risk-free investments depending on the creditworthiness of the issuing notion.

The higher rate of return you might anticipate from riskier investments, like equities, as opposed to risk-free investments, like government bonds, is known as a risk premium.

Calculating Equity Risk Premium

The ERP formula is derived from the capital asset pricing model (CAPM) formula.

This is often expressed as:

Ri = Rf + βi (Rm - Rf) 

Where:

The formula is a straightforward rewriting of the above formula: Equity Risk Premium =

Ri - Rf = βi (Rm - Rf)

If beta is equal to 1, and i = m, then ERP on the market = Ri - Rf. 

Equity Risk Premium (on the Market) = Rate of Return on the Stock Market − Risk-free Rate

Let us take an example. Assume the expected market return is 7% and the risk-free rate is 2%. If we subtract the risk-free rate from that of the market return, we get 5% as an ERP, which represents the investor's estimated profits over the risk-free rate.

Generally, a larger ERP correlates to a greater risk in the overall markets. A correction in the stock market may be applied if the current market valuations stay at the same (or higher) level despite declining equity risk premiums.

Markets reward investors more in the long run for accepting the higher risk associated with equity investments. This premium's exact calculation is up for debate. 

According to a study of academic economists, the typical range for a one-year horizon is 3% to 3.5%, and for a 30-year horizon, it is 5% to 5.5%.

Risk-Free Asset

A risk-free asset is safe, in which the predicted and actual returns are the same providing an assured future return and no loss chances. 

The United States Treasury Bills are considered the best example of a risk-free asset since they are safe and have an assured return. This explains why local and international investors purchase so many during a recession.

While all investments and assets have some level of risk, risk-free assets are renowned for their consistent future returns. Investors frequently consider these assets to be safe investments.

In other words, investments with little risk are seen to have a reasonable chance of attaining the anticipated return. 

The rate of return is frequently significantly lower to reflect the decreased level of risk because this benefit is virtually predictable. The difference between the predicted and actual returns is probably small.

Other examples of risk-free assets are listed below:

Although a risk-free asset's return is predictable, this does not ensure a gain in terms of buying power. Even if the dollar value has increased as anticipated, inflation may result in the asset losing buying power depending on how long it takes before maturity.

What is Market Risk vs. ERP?

The risk premium is commonly represented in the market risk premium and equity risk premium. The market risk premium is known as the additional return anticipated on an index or investment portfolio over the specified risk-free rate.

For example, if the interest rate of the Treasury bill is 3% and the S&P 500 generates a return of 7%, then the market premium is equal to the difference between the two returns.

Therefore: 

Market Risk Premium = Expected Rate of Return – Risk-Free Rate

The market risk premium is calculated by deducting the risk-free rate from the anticipated return on a portfolio of assets. So, if we consider the Treasury yields as the risk-free rate, the market risk premium of the portfolio is the difference between its returns and the selected Treasury yield.

The market risk premium cannot be in isolation from the Capital Asset Pricing Model (CAPM) and is determined by the slope of the security market line. At the same time, the ERP applies only to stocks and shows a stock's expected return over the risk-free rate.

Capital Asset Pricing Model and Equity Risk Premium

ERP and CAPM are examples of the numerous methods an investor might use to determine his personalized investing strategy.

The capital asset pricing model (CAPM), which makes clear that risk can be diversified and that not all risk can affect an asset's price, examines the impact of the risk premium of a specific investment on its expected returns.

CAPM uses the risk-free rate, the market risk premium, and the beta to determine the expected return of a specific stock.

The CAPM typically demonstrates the link between expected return and total market risk, also known as systematic risk. Investment risk is correlated with assets of a similar nature.

Investing in stocks may be an option for investors when the equity risk premium is high. Fixed-income securities are more appealing when they are low. 

This might be a useful consideration when deciding how to allocate money in your investment plan to stocks and bonds. The CAPM can help you think more critically about individual securities while emphasizing the part risk plays in expected return with particular stocks.

However, remember that the CAPM and the ERP are theoretical instruments based on past performance data. Noting that past performance is not a reliable indicator of future performance.

ERP and Dividend Discount Models

For theoretical and practical reasons, the ERP is undoubtedly one of the most fundamental numbers in asset pricing. 

A basic pricing model of the equity market is required to estimate future equity returns based on present conditions. 

The Dividend Discount Model is the cornerstone for most equity valuation techniques. It claims that the present value of the company's future cash flows and the stock price are equal.

The dividend discount model, sometimes known as the DDM, is a technique for valuing stocks that assumes a stock is worth the total of all of its potential dividends. 

Investors can estimate a stock's value based on the net present value of anticipated future dividends using the stock price, the company's cost of capital, and the value of the dividend due in the next year.

The ERP represents the market price of equity risk, theoretically speaking. It is also viewed as a gauge of overall risk aversion and plays a big role in how institutional and retail investors choose to allocate their assets. 

The equity risk premium has been utilized more recently as a metric of financial stability. 

The dividend discount model, first established by Gordon, is among the most widely used techniques to calculate the equity risk premium. Equity prices can be related to dividend anticipation and the premium.

Equity Risk Premium FAQs

Researched and authored by Sara Nasrallah | LinkedIn

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