What is Equity Risk Premium in CAPM?

In simple words, Equity Risk Premium is the return offered by individual stock or overall market over and above the risk-free rate of return. The premium size depends on the level of risk undertaken on the particular portfolio, and the higher the risk in the investment higher the premium will be. This risk premiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more also changes over time concerning the fluctuations in the market.

Equity Risk Premium Formula in CAPM

For calculating this, the estimates and judgment of the investors are used. The calculation of the Equity risk premium is as follows:

Firstly we need to estimate the expected rate of return on the stock in the market, then the estimation of the risk-free rate is required, and then we need to deduct the risk-free rate from the expected rate of return.

Equity Risk Premium Formula:

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The stock indexes like Dow Jones industrial average or the S&P 500 may be taken as the barometer to justify arriving at the expected return on stock on the most feasible value because it gives a fair estimate of the historical returns on the stock.

As we can see from the formula above that the market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities.read more is the excess return that the investor pays for taking the risk over the risk-free rate. The level of the risk and the equity risk premium is correlated directly.

Let’s take the example of a government bond giving a return of 4% to the investor; Now, in the market, the investor will choose a bond that will give a greater than 4% return. Suppose an investor choose a company stock giving a market return of 10%. Here the equity risk premium will be 10%- 4% = 6%.

Interpretation of Equity Risk Premium in CAPM

  • We know the risk associated with debt investment, as the investment in bonds, is usually lower than that of equity investmentEquity InvestmentEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.read more. Like that of preferred stock, there is no surety of receiving the fixed dividend from the investment in equity shares as the dividends are received if the company earns a profit and the dividend rate keeps on changing.

  • People invest in equity shares, hoping that the value of the share will increase shortly and they will receive higher returns in the long term. Yet there is always a possibility that the value of a share may decrease. This is what we call the risk that an investor takes.Moreover, if the probability of getting a higher return is high, the risk is always high. If the probability of getting a smaller return is high, then the risk is always lower, and this fact is generally known as a risk-return trade-off.The return that an investor on a hypothetical investment can receive without any risk of having financial loss over a given period is known as the risk-free rate. This rate compensates the investors against the issues arising over a certain period like inflation. The rate of the risk-free bond or government bonds having long-term maturity is chosen as the risk-free rate as the chance of default by the government is considered to be negligible.The riskier the investment, the more is the return required by the investor. It depends upon the investor’s requirement: risk-free rate and equity risk premium help determine the final rate of return on the stock.

Equity Risk Premium for US Market

Each country has a different Equity Risk Premium. This primarily denotes the premium expected by the Equity InvestorEquity InvestorAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc.read more. For the United States, Equity Risk Premium is 6.25%.

source – stern.nyu.edu

  • Equity Risk premium = Rm – Rf = 6.25%

Use of Equity Risk Premium in the Capital Asset Pricing Model (CAPM)

The CAPM model is used to establish the relationship between the expected return and the systematic risk of the securitiesSystematic Risk Of The SecuritiesSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more of the company. CAPM model is used to price risky securities and calculate the expected return on investment using the risk-free rate, expected rate of return in the market, and the beta of the security.

The equation for CAPM:

Expected Return on security = Risk-free rate + beta of security (Expected market return – risk-free rate)

= Rf +(Rm-Rf) β

Where Rf is the risk-free rate, (Rm-Rf) is the equity risk premium, and β is the volatility or systematic risk measurement of the stock.

In CAPM, to justify the pricing of shares in a diversified portfolio, It plays an important role in as much as for the business wanting to attract the capital it may use a variety of tools to manage and justify the expectations of the market to link with issues such as stock splitsStock SplitsStock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. read more and dividend yieldsDividend YieldsDividend yield ratio is the ratio of a company’s current dividend to its current share price.  It represents the potential return on investment for a given stock.read more, etc.

Example

Suppose the rate of return of the TIPS (30 years) is 2.50% and the average annual returnAnnual ReturnThe annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated using the geometric average. This return provides details about the compounded return earned yearly and compares the returns supplied by various investments like stocks, bonds, derivatives, mutual funds, etc.read more (historical) of the S&P 500 index by 15%, then using the formula equity risk premium of the market would be 12.50% (i.e., 15% – 2.50%) = 12.50%. So here, the rate of return that the investor requires for investing in the market and not in the risk-free bonds of the government will be 12.50%.

Apart from the investors, the company managers will also be interested as the equity risk premium will provide them with the benchmark return, which they should achieve for attracting more investors. For instance, one is interested in XYZ Company’s equity risk premium, whose beta coefficientBeta CoefficientThe beta coefficient reflects the change in the price of a security in relation to the movement in the market price. The Beta of the stock/security is also used for measuring the systematic risks associated with the specific investment.read more is 1.25 when the prevailing equity risk premium of the market is 12.5%. Therefore, he will calculate the company’s equity risk premium using the details given, which comes to 15.63% (12.5% x 1.25). This shows that the rate of return that XYZ should generate should be at least 15.63% for attracting investors to the company rather than risk-free bonds.

Advantages and Drawbacks

Using this premium, one can set the portfolio return expectation and determine the policy related to asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals.read more. For example, the higher premium shows that one would invest a greater portfolio share into the stocks. Also, CAPM relates the stock’s expected return to equity premium, which means that a stock with more risk than the market (measured by beta) should provide an excess return over and above equity premium.

On the other hand, the drawback includes the assumption that the stock market under consideration will perform in the same line as its past performance. No guarantee is there that the prediction made will be real.

Conclusion

This gives the prediction to the stakeholders of the company that the stocks with high risk will outperform when compared with less risky bonds in the long-term. There is a direct correlation between risk and the Equity risk premium. Higher the risk will be the gap between the risk-free rate and the stock returns, and hence premium is high. So it is a very good metric to choose stocks worth the investment.

This article has been a guide to Equity Risk Premium. Here we discuss its meaning and formula for calculating the equity risk premium, along with an example. We have also seen the advantages and drawbacks. You can learn more about it from the following articles –

  • Calculate Market Risk PremiumVolatility FormulaWhat is Audit Risk?Residual Risk