Equity Risk Premium
Candlefocus EditorThe risk-free rate is the rate used to compare other investments to, and it is an investment that carries no risk. This means that it is not exposed to the risk of loss. This is because such investments generally have a government guarantee, or have loan terms that ensure that the investor will get their principal at the end of the loan period plus interest at the agreed rate. Examples of risky-free assets include Treasury bills, government bonds, and CDs.
When calculating an equity risk premium, the investor should consider the historical returns of both the risk-free asset and the equity asset. If the return on the equity asset is higher than the risk-free rate, then the equity risk premium can be calculated by subtracting the risk-free rate from the equity return.
In determining whether an equity investment is worth making, many financial advisors recommend the use of the equity risk premium. This is because the ERP is an important indicator of what kind of return can be expected with a certain degree of risk. For example, a 10% ERP means that an investment in the equity market will yield a return of 10% more than a risk-free investment.
Ultimately, determining an equity risk premium is a complex process as there is no way of knowing exactly how well the equity market will perform in the future. That being said, the historical rate of return can give a reasonable estimate of the equity risk premium and can be used as a tool to help investors make informed decisions.