Definition: Equity risk premium, sometimes called simple equity premium, is the additional return an asset generates above and beyond the risk free rate. Since high-risk securities should have higher expected returns, this is a fundamental principle in the financial theory with respect to portfolio management and asset pricing.
What Does Equity Risk Premium Mean?
The expected return on a high-risk security is written as the sum of the risk-free rate and the equity risk premium, which is the extra return to compensate for the risk. The size of equity premium depends on the level of the undertaken risk in a portfolio as well as on the market fluctuations. Investors are willing to take on more risk if the reward is higher. This risk reward tradeoff is at the heart of the ERP.
Defining the factors that determine the ERP is the key objective of the valuation theory and its models, such as the capital asset pricing model (CAPM). To calculate the equity risk premium, we need to know:
- rf = the risk-free rate
- b = the beta of the security
- rm = the market return.
Let’s look at an example.
Nick is a finance associate at Jacobs Securities. His supervisor at the research department has asked Nick to calculate the ERP for a consumer goods company that trades on the NYSE.
Over the past five years, Nick is following the S&P 500 for statistical reasons. Now, he checks on the S&P 500 index to find the risk-free rate. Nick finds that the risk -free rate is equal to the 10-year U.S. Treasury rate 1.45%. He also knows that the beta of the security is 1.5, and the market return is 12.2%.
Nick calculates the equity risk premium of the security as follows:
ERP = b × (market return – risk-free rate) = 1.5 x (12.2% – 1.45%) = 1.5 x 10.75% = 0.1613 = 16.13%
Therefore, 16.13% represents the return that investors require from the stock, which exceeds the risk-free rate of 1.45%, in order to undertake the risk of investing in this stock.