Equity risk premium
The return investors expect from equities above the risk-free rate. It cannot be observed, so it is estimated from history, from dividend or earnings models, or from surveys.
Where you will meet it
Equity risk premium appears in 7 learning outcomes on the CFA syllabus. A few of them:
- Estimate the return equity holders require with both the market model and the CAPM
“The capital asset pricing model estimates the required return on equity as the risk-free rate plus beta times the equity risk premium: r = Rf + beta x (E(Rm) - Rf).”
- Work out the cost of both common and preferred equity
“The capital asset pricing model estimates it as the risk-free rate plus beta times the equity risk premium.”
- Contrast the models for estimating the return required on private company equity, such as the build-up approach, the CAPM and the expanded CAPM
“The CAPM, r = rf + β × equity risk premium, needs a beta, usually from guideline public companies, and may miss size and company-specific risk.”
- Explain how the equity risk premium is linked to how well equities hedge consumption
“Equities behave the opposite way: profits and prices tend to fall in recessions, exactly when investors most need money, so they are poor consumption hedges and must offer a sizeable equity risk premium above that on default-free bonds.”
See also
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Practise equity risk premium until it is automatic: questions that explain every wrong option.
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