The easiest method for investors to generate income from their investments is to invest in risk-free instruments. It allows investors to earn money without having to take risks. However, the returns on these investments are lower as compared to others. If investors want to make higher returns, they must accept the risk associated with other instruments.
However, investors must also determine whether investing in other instruments will yield them higher returns as compared to risk-free instruments. Therefore, they must use what is known as the risk premium on their investments.
What is Equity Risk Premium?
Equity risk premium represents the difference between the returns on equity or stocks of a company and the risk-free rate of return. Usually, the risk-free rate of return is the return that investors get from government bonds as they, usually, have negligible risks. Another definition of equity risk premium is the excess amount of return that investors get from a stock above the risk-free rate of return.
The equity risk premium of a stock depends on several factors. Firstly, it depends on the risk that investors are willing to take on an investment. The higher the risks they take, the more their equity risk premium will be. Similarly, it also depends on the risk-free rate of return. If government bonds have low returns, then the equity risk premium will increase.
How to calculate Equity Risk Premium?
The formula to calculate the equity risk premium of a stock is as below.
Equity Risk Premium = Rate of return of the market – Risk-free rate of return
As mentioned above, it takes two factors into consideration, the rate of return of the market and the risk-free rate of return. In this formula, investors can use the return of a specific index of the stock exchange as the rate of return of the market. Similarly, for the risk-free rate of return, investors can use the rate of long-term government securities.
Investors can also calculate the equity risk premium of a stock by rearranging the Capital Asset Pricing Model formula. After rearrangement, the formula becomes:
Equity Risk Premium = Beta x (Expected return of market – Risk-free rate of return)
What are the benefits of using Equity Risk Premium?
Equity risk premium can provide many advantages to investors. First, it is easy to use and calculate, which any investor can calculate. Similarly, it gives investors an idea of whether investing in stock will yield positive results. Furthermore, the equity risk premium is necessary and used in various models such as the Capital Asset Pricing Model, which can help in calculating the cost of capital.
What are the limitations of Equity Risk Premium?
Equity risk premium may also come with some limitations. These limitations come mainly due to the assumptions that investors make when calculating it. Based on these assumptions, investors can get inaccurate results. Overall, it may produce an inconsistent result for various investors calculating the equity risk premium of the same stock.
Conclusion
The equity risk premium is the difference between the return investors expect from stock and the risk-free rate of return. It helps investors determine whether they should invest in a stock or not. The higher the risks investors are willing to take, the higher the equity risk premium they can expect.
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