EQUITY RISK PREMIUM

The notion that risk matters, and that riskier investments should have a higher expected return than safer investments to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the risk-free rate and an extra return to compensate for the risk. The disagreement, in both theoretical and practical terms, remains on how to measure this risk, and how to convert the risk measure into an expected return that compensates for risk. This section looks at the estimation of an appropriate equity risk premium (ERP) to use in risk and return models, in general, and in the capital asset pricing model, in particular.

Competing Views on Risk Premiums

In Chapter 4, we considered several competing models of risk ranging from the capital asset pricing model to multifactor models. Notwithstanding their different conclusions, they all share some common views about risk. First, they all define risk in terms of variance in actual returns around an expected return; thus, an investment is riskless when actual returns are always equal to the expected return. Second, they all argue that risk has to be measured from the perspective of the marginal investor in an asset, and that this marginal investor is well diversified. Therefore, the argument goes, it is only the risk that an investment adds on to a diversified portfolio that should be measured and compensated. In fact, it is this view of risk that leads mo....