3The notion that risk matters, and that riskier investments should have higherexpected returns than safer investments, to be considered good investments, is bothcentral to modern finance and intuitive. Thus, the expected return on any investment canbe written as the sum of the riskfree rate and a risk premium to compensate for the risk.The disagreement, in both theoretical and practical terms, remains on how to measure therisk in an investment, and how to convert the risk measure into an expected return thatcompensates for risk. A central number in this debate is the premium that investorsdemand for investing in the ‘average risk’ equity investment, i.e., the equity riskpremium.In this paper, we begin by examining competing risk and return models in financeand the role played by equity risk premiums in each of them. We argue that equity riskpremiums are central components in every one of these models and consider what thedeterminants of these premiums might be. We follow up by looking at three approachesfor estimating the equity risk premium in practice. The first is to survey investors ormanagers with the intent of finding out what they require as a premium for investing inequity as a class, relative to the riskfree rate. The second is to look at the premiumsearned historically by investing in stocks, as opposed to riskfree investments. The third isto back out an equity risk premium from market prices today. We consider the pluses andminuses of each approach and how to choose between the very different numbers thatmay emerge from these approaches.
Equity Risk Premiums: Importance and Determinants
Since the equity risk premium is a key component of every valuation, we shouldbegin by looking at not only why it matters in the first place but also the factors thatinfluence its level at any point in time and why that level changes over time. In thissection, we look at the role played by equity risk premiums in corporate financialanalysis, valuation and portfolio management, and then consider the determinants of equity risk premiums.
Why does the equity risk premium matter?
The equity risk premium reflects fundamental judgments we make about howmuch risk we see in an economy/market and what price we attach to that risk. In theprocess, it affects the expected return on every risky investment and the value that weestimate for that investment. Consequently, it makes a difference in both how we allocatewealth across different asset classes and which specific assets or securities we invest inwithin each asset class.