The difference between a market-risk premium and an equity-risk premium comes down to scope. The market risk premium is the additional return that's expected on an index or portfolio of investments above the given risk-free rate.

On the other hand, an equity risk premium pertains only to stocks and represents the expected return of a stock above the risk-free rate. Equity-risk premiums are usually higher than standard market-risk premiums. Typically, equities are considered riskier than bonds, but less risky than commodities and currencies.

Key Takeaways

  • The market risk premium is the additional return that's expected on an index or portfolio of investments above the given risk-free rate.
  • The equity risk premium pertains only to stocks and represents the expected return of a stock above the risk-free rate.
  • Since Treasuries are backed by the U.S. government, they're considered risk-free, and their yields are used as a proxy for a risk-free rate.

Understanding Market and Equity Risk Premiums

Investments have varying degrees of risk associated with them. If an investor buys a stock, for example, there's a risk that the stock price could decline, which opens up the possibility of the investor incurring a loss when the position is sold.

As a result, investors demand compensation for assuming risk and the investments that carry more risk, should offer additional opportunity to earn a gain. Investors weigh the risk versus reward in any position.

However, U.S. Treasury bonds are typically considered risk-free returns if the bond is held to maturity. In other words, since Treasuries are backed by the U.S. government, their yields or interest rates are considered risk-free. As a result, Treasuries are typically used as a benchmark when calculating the risk-free rate that investors could earn had they invested in Treasuries versus the investment they're considering.

In other words, an investment should, at the very least, earn the risk-free rate; otherwise, it wouldn't be worth the risk.

The difference between the risk-free rate and the rate on non-Treasury investments is the risk premium. When the non-Treasury investment is a stock, the premium is referred to as an equity risk premium. On the other hand, when the non-Treasury investment is a portfolio or a market index such as the S&P 500, the premium is referred to as the market risk premium.

Market Risk Premium

Market risk premium is the difference between the forecasted return on a portfolio of investments and the risk-free rate. Since Treasuries are considered the risk-free rate, the market risk premium for a portfolio is the variance between the returns on the portfolio and the chosen Treasury yield.

There are various types of market risk premiums, depending on what the investor is trying to determine. A historical analysis might analyze the difference between a portfolio's return over the last two years, for example, and the two-year Treasury yield during that period. When comparing historical market-risk premiums, the process is fairly straightforward. However, a portfolio's past performance is not a predictor of future returns.

If an investor is comparing the market risk premium based on the expected return of a portfolio versus the current two-year Treasury yield, the result is subject to human inference. As a result, the expected or forecasted market risk premium can vary between investors since each has its biases, risk-tolerance levels, and views on the market.

To illustrate, suppose an individual has $10,000 to invest. She could place the money in Treasury bonds for a relatively low rate of return, say 2% per year. If she chooses the T-bonds, she has virtually zero chance of losing her principal. Any return above and beyond the 2% is the market risk premium required by investors to commit their money to a portfolio or an index.

The Treasury isn't the only institution that wants her money, however. Corporations offer bonds and stocks to raise capital or money, but they can't offer the same kind of safety that comes with T-bonds. Corporations have to increase the offered return on their instruments to entice the investor to place her money with them.

Equity Risk Premium

Equity risk premium refers to the additional return from investing in a stock that's above the risk-free rate. Similar to a market risk premium, equity risk premiums compensate investors for taking on additional risk that comes with buying and selling stocks.

The extent of the premium can vary as the stock price fluctuates, and as changes occur within the underlying company. The premium depends on the level of risk for the stock or group of stocks being considered. High-risk stocks often have higher risk premiums.

Equity returns can fluctuate depending on the overall macroeconomic conditions in the global economy. If, for example, U.S. consumer spending is declining, stocks that benefit from consumers, such as retailers, would likely have a higher risk of loss associated with them. Of course, the return on a company's stock is also dependent on many internal factors, including the company's financial performance, the effectiveness of its management team, as well as its product and service offerings.

Equity risk premiums exist because investors demand a premium on the returns for their equity investments versus the returns from low-risk investments or risk-free investments such as Treasuries. In short, if an investor's money is at a greater risk for a loss, a higher premium is likely needed to entice them to buy.