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Definition of Equity Risk Premium
- It is the difference between expected returns from the stock market and the expected returns from risk-free investments.
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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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.