What does equity risk premium measure?

The equity risk premium is a crucial concept in finance that quantifies the additional return that investors require for taking on the increased risk of investing in equities compared to risk-free assets, such as government bonds. This premium reflects the idea that investors demand higher returns for bearing higher risk, which is fundamental to investment theory.

When considering investments, risk-free assets are characterized by their predictable returns, while equities involve a greater degree of uncertainty and volatility. The equity risk premium, therefore, captures the excess return that compensates investors for this additional risk. It is a critical component in asset pricing models, helping investors evaluate whether equities are worth the risk compared to safer investments.

Understanding this premium is essential for making informed investment decisions and assessing whether the expected returns justify the risks involved in equity markets. This makes the concept particularly relevant for both individual and institutional investors who seek to optimize their portfolios based on their risk tolerance and investment goals.