Definition Of Equity Risk Premium In Finance

Equity risk premium the return that an investor expects over and above the risk free rate of return in exchange for investing in common stock instead of u s.

Definition of equity risk premium in finance. Examples of risk premium in the following topics. Equity risk premium also called equity premium is the return on a stock in excess of the risk free rate which must be earned by the stock to convince investors to take on the risk inherent in it. Where r f is the risk free rate r m r f is the equity risk premium and β is the volatility or systematic risk measurement of the stock. The equation for capm.

It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk free securities. The risk premium on its equity is 4. 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. The most important number in finance is the equity risk premium the return that investors can expect from holding the market portfolio of common stocks in excess of the return on 20 year government securities.

Equity risk premium sometimes called simple equity premium is the additional return an asset generates above and beyond the risk free rate. Equity risk premium is the difference between returns on equity individual stock and the risk free rate of return. The normal historical equity risk premium for all equities has been just over 6. In general an equity s risk premium will be between 5 and 7.

The bond yield plus risk premium approach. This return compensates investors for taking on the higher risk of. Expected return on security risk free rate beta of security expected market return risk free rate r f rm rf β. For example if the interest rate on a treasury bond is 4 and the stock.

The equity risk premium may be calculated as the return such a stock actually earns over a given period. In capm to justify the pricing of shares in a diversified portfolio it plays an important role in as. Describe the process for the bond yield plus risk. Equity risk premium is an important input in determination of a company s cost of equity under the capital asset pricing model capm and its stock valuation.