Topic 25
Equity Risk Premiums
Topic 25 explores the background to the determination of the equity risk premium and how it is used in the capital asset pricing model (CAPM) as introduced in Topic 23.
EQUITY RISK PREMIUM DEFINED
- As reported by Ibbotson Associates, the overall equity return for large-company equity securities as a whole on the U.S. equity markets in excess of risk-free rates over the last 84 years for the period ending December 31, 2009, is 6.7%.1
- The large-company equity risk premium equals the actual arithmetic average of the long-term total return of the stock market as included in the Standard & Poor's (S&P 500) return index, less the arithmetic average government bond income return, the risk-free rate.2
- Ibbotson Associates currently uses the income return of a series of Treasury bonds with approximately 20 years to maturity as the risk-free rate in determination of the equity risk premium.3 Although the 30-year Treasury bond is preferable for this purpose, that bond was introduced only in 1977 (and subsequently has been withdrawn and reintroduced).4
- Equity risk premiums are opportunity based—you should expect to realize this premium on equity investments versus risk-free investments, so you should expect to get at least such a premium from an acquisition.
- A frequently used source for equity risk premium data is from Ibbotson Associates, a subsidiary of Morningstar, Inc., which provides and updates this data annually, provides exceptionally well-documented literature, ...
