How to Calculate Equity Risk Premium

The market risk premium is the rate above the risk free premium paid to investors.

Equity risk premium is the excess return a stock receives over the risk free rate. This amount represents a premium paid to the investors for taking a higher risk than risk free. Typically, investors use treasury bills as the risk free rate because they are relatively risk free since they are backed by the government. The higher the risk of an investment, the higher the investor will want the equity risk premium.

Instructions

1. Determine the rate on a three-month U.S. treasury bill. This amount is typically the risk-free rate. The three-month U.S. treasury bill rate is listed on the U.S. Treasury website. For example, on May 3, 2010, the three-month U.S. treasury bill rate was 0.17 percent.

2. Determine the rate of return on the investment. For example, a stock had a return of 3 percent.

3. Subtract the risk-free rate from the rate of return on the investment to determine the equity risk premium. In our example, 3 percent minus 0.17 percent equals an equity risk premium of 2.83 percent.

References

• Investopedia: Equity Risk Premium
• U.S. Treasury: Daily Treasury Bill Rates
• Investopedia: Risk-Free Rate of Return