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Stocks and bonds carry investment risk. Buyers demand a premium return or a discounted cost from sellers or issuers in exchange for assuming investment risk. The premium on that risk could theoretically be the same, but equities have historically carried a higher risk premium than bonds.

Measuring Market Risk Premium

The standard equation used to calculate equity risk premium is the return on asset or investment minus the risk-free return for same duration. If the risk-free rate is 2%, an asset offering 5% carries a risk premium of 3%.

According to mainstream finance theory, the risk-free return is any investment that carries no risk; U.S. Treasury bills are typically used as a proxy for the risk-free investment. This risk only includes default risk or absolute loss, not opportunity costs or inflation risk.

For example, T-bills have virtually zero chance of default. This means the investment will not lose any nominal value. However, the rate of inflation might exceed the risk-free rate of return on T-bills, meaning that purchasing power might decline over time.

The risk premium on bonds is more commonly known as the credit spread. The standard formula for a corporate credit spread is the corporate bond yield minus the 10-year treasury yield.

Market Risk Premium for Stocks and Bonds

According to research from NYU, the geometric average risk premium on stocks relative to T-bills was 6.11% from 1928 to 2014. In other words, the stocks had to provide an average return of 6.11% above the rate of return on T-bills to entice an investor to give up the risk-free rate.

Similar research from Stanford University found that, from 1866 to 2011, the geometric average credit spread on corporate bonds was only 1.53%.

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