How does equity risk premium work

Shares are generally considered to be a high risk investment. Investing in the stock market comes with certain risks, but it also has the potential for significant gains. Therefore, as a general rule, investors are compensated at higher premiums when they invest in the stock market. Whatever return you earn on a risk-free investment like a US Treasury (T-bill) or bond, it is called a equity risk premium.

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Equity risk premium is based on the notion of trade-off between risk and reward. He is a forward-looking character, and as such, ALQST is theoretical. But there is no real way to know how much an investor will get, as no one can actually say how well the stock or stock market will perform in the future. Instead, the equity risk premium is an estimate as a backward measure. It monitors the performance of the government securities and bonds market over a specific period of time and uses this historical performance to achieve future returns. Estimates vary widely depending on the time frame and method of calculation.

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Because equity risk premiums require the use of historical returns, it is not an exact science, and therefore it is not completely accurate.

To calculate the equity risk premium, we can start with the Capital Asset Pricing Model (CAPM), which is usually written as Ra = Rf + βa (Rm - Rf), where:

Ra = the expected return on an investment in an investment or a capital investment of some kind

Rf = Risk Free Rate of Return

βa = beta of A.

Rm = expected market return

Therefore, the equation for equity risk premium is a simple restatement of CAPM which can be written as follows: Equity risk premium = Ra - Rf = βa (Rm - Rf)

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If we are talking simply about the stock market (a = m), then Ra = Rm. Beta is a measure of a stock's volatility - or risk - versus market volatility. Market volatility is conventionally determined as 1, so if a = m, then βa = βm = 1. Rm - Rf is known as market premium, and Ra - Rf is the risk premium. If a is a capital investment then Ra - Rf is the equity risk premium. If a = m, then the market premium and equity risk premium are the same.

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According to some economists, this is not a generalizable concept although some markets in certain time periods may exhibit a significant equity risk premium. They argue that an excessive focus on specific cases has made statistical privacy appear to be an economic law. Many exchanges have gone bankrupt over the years, so focusing on the historically exceptional US market may distort the picture. This focus is known as a survival bias.

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Most economists agree, although the concept of equity risk premium is correct. In the long term, the markets more than compensate investors for taking greater risk of investing in stocks. How exactly this premium is calculated is disputed. A survey of academic economists gives a median range from 3% to 3.5% for one year, and 5% to 5.5% for 30 years. CFOs estimate the premium will be 5.6% on Treasury bills. The second half of the twentieth century saw a relatively high equity risk premium, over 8% according to some accounts, as opposed to less than 5% in the first half of the century. Given that the century ended at the height of the internet bubble, this random window may not be ideal.

Equity risk premium

Special considerations

The above equation summarizes the theory behind the equity risk premium, but it does not take into account all possible scenarios. The calculation is fairly simple if you plug in the historical rates of return and use them to estimate future rates. But how do you estimate the expected rate of return if you wish to make a forward-looking statement?

One way is to use dividends to estimate long-term growth, using a reformulation of the Gordon growth model: k = D / P + g


k = expected return expressed as a percentage (this can be calculated for Ra or Rm)

D = Earnings per share

P = share price

g = annual growth in dividends expressed as a percentage

Another is to use growth in profits, rather than growth in profits. In this model, the expected return is equal to the dividend yield, reciprocally to the price-earnings ratio (P / E ratio): K = E / P


K = expected return

E = Earnings per share for twelve months (EPS)

P = share price

The disadvantage of both models is that they do not take into account evaluation. That is, they assume that stock prices are never correct. Since we can observe the booms and crashes of the stock market in the past, this defect is not an easy matter.

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Finally, the risk-free rate of return is usually calculated using US government bonds, since they have little chance of default. This could mean Treasury Bills or Treasury Bonds. To arrive at a real rate of return, that is, to adjust it according to inflation, it is easier to use Treasury Inflation Protected Securities (TIPS), since it really represents inflation.