What Is Equity Risk Premium?

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Definition of Equity Risk Premium

  • It is the difference between expected returns from the stock market and the expected returns from risk-free investments.

What Impacts the Equity Risk Premium?

  • Market expected return:
    • Stock prices are influenced by internal factors (management), economic factors, political factors, demand, and supply, etc.
    • Dividends
  • Risk-free rate:
    • The risk-free rate is the government bonds yield; therefore, it is strongly influenced by the inflation rate.
    • Additional factors that influence the risk-free rate are macroeconomic factors, monetary policies, external and structural factors.

How Do You Calculate Equity Risk Premium?

  • Equity risk premium can be calculated by subtracting the expected risk-free rate from the market expected return.

Equity risk premium = Market Expected Return (Rm) – Risk-free rate (Rf)

  • There are two methods of calculating expected market returns, an earnings-based or a dividend-based approach.
    • Earnings model → Expected return = earnings per share
    • Dividend model → P0 = D/(r g)

Why is the Equity Risk Premium Important?

  • Knowing the equity risk premium, investors would be able to allocate their money more efficiently.
  • If the equity risk premium is high, investors should invest in stocks because the high-risk should ensure them a high return on investment.
  • If the equity risk premium is low, investors should invest in government bonds as it is less risky.

What Could Go Wrong With the Equity Risk Premium?

  • To calculate risk premiums, there are a few assumptions that have to be made.
  • Equity risk premium might not be a good indicator for making decisions on whether to buy stocks or bonds.
  • One study by the US Federal Reserve analyzed 20 different ways to calculate the equity risk premium and determined that the result was very different.
  • In the end, people using the equity risk premium must use it as a guide, rather than mathematical certainty.

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