What is an Equity Risk Premium?

Equity risk premium refers to rate of profit or return that can be earned on financial instruments above the average rate of return. The equity risk premium is an incentive which motivates risky investors to invest in high-risk assets. The extent of the risk premium depends upon the level of risk in a specific security or portfolio, and the rate changes with the market.

How Does an Equity Risk Premium Work?

The value of risk premium depends on the possibility of the risk reward tradeoff. As a forward-looking amount, the value of the risk premium is hypothetical, as nobody knows how a specific stock will perform later on. To estimate the value risk premium for a particular security, analysts employ the capital assets pricing model (CAPM), which is generally expressed as: Ra = Rf + a (Rm – Rf) Where: Ra = expected rate of return in “a” RF = risk free rate of return a = beta of “a” Rm = expected return of market