Equity Risk Premium

AAA

DEFINITION of 'Equity Risk Premium'

The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium.

Also referred to as "equity premium".

VIDEO

Loading the player...

BREAKING DOWN 'Equity Risk Premium'

The reason behind this premium stems from the risk-return tradeoff, in which a higher rate of return is required to entice investors to take on riskier investments. The risk-free rate in the market is often quoted as the rate on longer-term government bonds, which are considered risk free because of the low chance that the government will default on its loans. On the other hand, an investment in stocks is far less guaranteed, as companies regularly suffer downturns or go out of business.

If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% for this stock over that period of time.

RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. International Capital Asset Pricing ...

    A financial model that extends the concept of the capital asset ...
  3. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  4. Premium

    1. The total cost of an option. 2. The difference between the ...
  5. Risk-Return Tradeoff

    The principle that potential return rises with an increase in ...
  6. Risk

    The chance that an investment's actual return will be different ...
Related Articles
  1. Fundamental Analysis

    Calculating the Equity Risk Premium

    Equity risk premium is the excess expected return of a stock, or the stock market as a whole, over the risk-free rate.
  2. Bonds & Fixed Income

    Why Stocks Outperform Bonds

    Why have stocks historically produced higher returns than bonds? It's all a matter of risk.
  3. Fundamental Analysis

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  4. Options & Futures

    Calculating The Equity Risk Premium

    See the model in action with real data and evaluate whether its assumptions are valid.
  5. Fundamental Analysis

    The Equity-Risk Premium: More Risk For Higher Returns

    Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium.
  6. Bonds & Fixed Income

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  7. Bonds & Fixed Income

    Equity Premiums: Looking Back And Looking Ahead

    If stocks become less profitable in the future, you may have to change your investment strategy.
  8. Investing Basics

    Calculating the Margin of Safety

    Buying below the margin of safety minimizes the risk to the investor.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  10. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
RELATED FAQS
  1. How does the equity risk premium correlate with the Federal Reserve's prime rate?

    The equity risk premium correlates negatively with the Federal Reserve's prime rate. When the prime rate is declining, the ... Read Full Answer >>
  2. What does a high equity risk premium signify about a company's stock future?

    A high equity risk premium signifies that a company's stock future is uncertain. Equity risk premium is the excess return ... Read Full Answer >>
  3. What is the correlation between equity risk premium and risk?

    The equity risk premium refers to the amount of additional return an investor can obtain from investing in an asset over ... Read Full Answer >>
  4. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  5. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  6. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
  2. Bear Market

    A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment ...
  3. Alligator Spread

    An unprofitable spread that occurs as a result of large commissions charged on the transaction, regardless of favorable market ...
  4. Tiger Cub Economies

    The four Southeast Asian economies of Indonesia, Malaysia, the Philippines and Thailand. Tiger cub economy indicates that ...
  5. Gorilla

    A company that dominates an industry without having a complete monopoly. A gorilla firm has large control of the pricing ...
  6. Elephants

    Slang for large institutions that have the funds to make high volumes trades. Due to the large volumes of stock that elephants ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!