Equity Risk Premium

All securities are subject to market risks. Equities or stocks earn profits over definite time periods. Most of these securities earn a risk-free interest or generate a minimum assured income. Additional return equity gives over and above this minimum sum is termed ‘equity risk premium’. Equity risk premium in effect compensates relatively higher risk investors take when they invest in public securities or stocks. When higher risk is involved the greater the premium paid.

Also termed ‘equity premium’, it arises from risk-return tradeoff which involves investing in riskier equities. To motivate investors in relatively more risky investments it is important to offer additional premium. Risk-free return is comparable to government bond earnings which usually are paid as per long term interest rates. Since government securities face minimum or no risk, earnings are low. Investments in joint-stock companies involve much greater risk as they may face losses or go out of business. As such it becomes necessary for them to entice investors with lucrative interest rates.

For instance, if the risk-free earning rate is 8% as compared to 14% on said stock, then equity-risk premium works out to 6% for investing in this security, over the same time period.

In other terms, the equity risk premium is a quantitative difference between the rate of return on stocks and Treasury bills. Equity risk premium figures are particularly important when it comes to risk determination and investment strategy. Thus, for instance, a higher equity risk premium would favour a stock oriented asset allocation. Calculating equity risk premium with great accuracy remains challenging. Professionals often employ a supply-side model to arrive at diligent equity risk premium parameters. The measure of equity risk premium may likewise be applied to individual stocks, not merely the overall market.

The historical concept of equity risk premium

The earliest concept of equity risk premium is perhaps found in John Stuart Mill’s ‘Principles of Political Economy’ published in 1848. John Mill segregates profit into three parts:

1. Interest for capital borrowed, which is similar to the risk-free rate and determined by the opportunity cost of money
2. Value of risk factor involved with an investment, which is comparable to ‘equity risk premium’.
3. Surplus profit, which is relatively very small

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