Definition
Risk premiums compensate investors for various types of risk beyond the risk-free return. The equity risk premium (ERP) is the extra return stocks are expected to provide over government bonds—historically around 5-7% annually. Other premiums include size premium, value premium, country risk premium, and illiquidity premium.
functions Formula
Required Return = Risk-Free Rate + Risk Premium
lightbulb Example
Equity risk premium is 5.5%, risk-free rate is 4%. A stock with beta 1.2 has a risk premium of 1.2 × 5.5% = 6.6%, and required return = 4% + 6.6% = 10.6%.
verified_user Key Points
- Equity risk premium averages 5-7% historically
- Higher risk premiums for smaller, riskier investments
- Country risk premium added for emerging markets
- Illiquidity premium for private investments