The formula to calculate the Equity Risk Premium (ERP) is:
\[ ERP = Rm - Rf \]
Where:
Let's say the expected return on the market (\( Rm \)) is 8%, and the risk-free rate (\( Rf \)) is 3%. Using the formula:
\[ ERP = 8 - 3 \]
We get:
\[ ERP = 8 - 3 = 5 \% \]
So, the Equity Risk Premium (\( ERP \)) is 5%.
The Equity Risk Premium is the excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular investment or market. It is an important concept in financial investing and fundamental to the Capital Asset Pricing Model (CAPM).