Definition of Equity Risk Premium
- It is the difference between expected returns from the stock market and the expected returns from risk-free investments.
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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.
- 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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