Equity risk premium at a glance!
One universal law, which forms the base of the financial world, is the risk & return law: Higher the risk, the higher the return. Various risk premia are the outputs of the fundamental law. The equity risk premium is one of the basic and prominent amongst all. An investor should be aware of the risk profile of equity markets and the returns that can be expected. Let us try to dig deeper into various risk exposures.
For any country, investment in government bonds or debt is considered the least-risky investment or the safest investment of all. Although no one can say with a hundred per cent assurance that government will never default. However, we can at least say that government bonds have negligible risk, very low since the government can print the money and save itself from default in the worst-case scenario. The rate of return for a particular period that can be earned on a government bond is referred to as the risk-free rate (RFR). In India, RFR on a one-year maturity bond is at a ballpark number of 4 per cent. And for 10-year maturity, it is 6.1 per cent. Equity risk premium (ERP) is the additional return above the RFR that can be expected to earn for holding equities. In simpler words, investors are taking additional risks by investing in equities and so, they expect an additional return or risk premium over RFR.
The derivation of equity risk premium might be a little complex but we can understand the key factors that affect ERP. One of the major determinants is the risk aversion of investors. The higher the risk aversion, the higher will be the ERP. The older population has high-risk aversion relative to younger ones and thus, demands high ERP. Another major factor in play is the economic risk. Strong and stable economies have relatively lower ERP. For example, the US has lower ERP than India, based on the overall economic outlook. The third factor can be the liquidity in the equity markets. Lesser liquidity in the markets leads to higher transaction costs, which are a significant risk for an investor. And hence, the higher the liquidity, the lower will be ERP and vice-versa. According to RBI, ERP in India averaged at 4.8 per cent as of 2020.
Why is it important?
ERP is a fundamental variable in various valuation models. One of the popular valuation models is the capital asset pricing model (CAPM). CAPM is used to determine the returns that can be expected from a particular stock. Various institutions track the ERP to approximate future economic outlook and take necessary actions.
Next time, when you make an investment decision, make sure you have studied the equity risk premium as well as the risk profile of the particular company.