- Another important element
of the capital asset pricing model
is something called the equity risk premium.
Now, in this context, equity means an investment
in the ownership shares of a company.
Equity stock investments are what we're talking about,
and the simple insight is this.
An investment in the shares of a company is more risky,
say, than an investment in a bank account,
so there should be a higher rate of return.
If you invest in a bank account,
there is almost no risk at all,
so the return that you're going to earn is low.
But if you're investing in stocks,
then there's much more risk,
so you will expect a higher return.
In the United States, for example,
over the 50, 60, 70 years,
an investment in stocks has averaged a return
of about 10 to 11% per year.
The equity risk premium is the extra amount you expect
to earn on your investment
because you are investing in risky assets.
Now, recall that the number
we are remembering for the risk-free
rate is, that's right, 5%.
5% is the risk-free rate.
The rate that you have been
able to earn in the United States
and around the world over the last 50, 60, 70 years
on investments in equities or stocks is about 11%.
The difference between those two,
the 5% risk-free rate and the 11% rate on equity investments
is what we're going to call the equity risk premium,
the extra amount that you earn on an investment
because you are willing to accept some risk,
the equity risk premium.
In summary, the risk-free rate is 5%.
We remember that from before.
An investment in a broad portfolio of stocks,
an equity investment makes about 11%.
The equity risk premium
that we will use is 6%, the difference between five and 11.
So I want you to remember those two numbers, five and six.
Five, that's what we'll use for the risk-free rate,
six, that's the extra amount we are
going to be able to earn by being willing
to accept risk to invest in stocks,
equity investments, the equity risk premium.
Now, there are lots of warnings here,
so if you are a finance professor,
I want you to just calm down.
I know there are lots of things
that we could talk about here,
we're just talking about investment in small firms
or large firms, are we talking about risk-free rate,
are we talking about short-term rates,
long-term rates, what exactly
are we talking about, we don't care.
For you and I, let's just remember the two numbers,
the risk-free rate, 5%.
Equity risk premium, 6%.