Equity Risk Premium Explained: Understanding Investment Risk & Return

The equity risk premium is a term that is commonly used when talking about securities in the stock market. Here are the basics of the equity risk premium and how it works.

Equity Risk Premium

One of the most basic fundamentals of investment is that in order to obtain a reward, you are going to have to take a risk. As the potential rewards increase, the risk is going to increase also. In investing, there is an interest rate that is known as the risk-free rate. Typically, this rate is associated with long-term government bonds. Investors believe that these bonds should be considered to be risk-free because there is not a very high likelihood that the government is going to go under. The equity risk premium is the amount of interest that you can earn over the risk-free rate by taking on a particular investment.

Example

Let's say that you are thinking about investing in a stock that will pay 10 percent return over the course of a year. If the risk-free rate on government bonds was 4 percent over the course of the year, the equity risk premium in this case would be 6 percent.