Definition
Equity Risk Premium
The equity risk premium is the extra return investors expect from stocks over risk-free assets, compensating for higher risk.
Stocks are riskier than government bonds, so investors demand a higher expected return, the equity risk premium (ERP), over the risk-free rate (proxied by the 10-year G-Sec yield). A common rough gauge is the gap between the market's earnings yield (inverse of P/E) and the bond yield.
When bond yields rise, the relative appeal of equities falls unless earnings yields rise too, which can pressure valuations. The ERP frames the eternal trade-off between safe fixed income and riskier, higher-return equities in asset allocation.
Related terms
- Coupon and Yield (Bonds)A bond's coupon is its fixed interest rate on face value, while yield is the actual return based on the price you pay, which moves inversely to price.
- Risk-Reward RatioThe risk-reward ratio compares the potential loss of a trade to its potential gain, guiding whether a setup is worth taking.
- Repo RateThe repo rate is the interest rate at which the RBI lends short-term money to commercial banks, and it is the central bank's main tool to balance inflation and growth.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.