Equity Risk Premium

Posted in Finance, Accounting and Economics Terms, Total Reads: 638
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Definition: Equity Risk Premium

The extra return that an investor demands over the risk free rate of market to compensate for the relatively higher risk associated with particular stock in correlation with investor portfolio or market. Higher risk premium is provided to attract investors to riskier equities.

Example:

If the required rate on return of a stock is 13% and 7% is the risk free rate of relevant market, then 6% is the risk premium.

Formulae:

Where

Re=Rf+Rp

Re=Required return on equity

Rf=Risk Free Rate

Rp=Risk Premium


Risk free rate is the theoretical rate of return on an investment with zero risk.  Required rate of return is the minimum return that an investor requires to invest in a riskier project. The risk premium will be different for different investors depending on their risk taking capabilities. A risk adverse investor may demand higher premium as compared to a risk taking investor. The risk premium covers only diversifiable risk (non-systematic) as non diversifiable risk (market or systematic risk) can’t be eliminated.

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