The Equity Risk Premium
Stocks vs Bonds
Section titled “Stocks vs Bonds”When a company needs money, there are two ways to raise it:
- Issuing bonds or asking for loans in exchange for interest plus the return on the principle amount
- Or issuing stocks by selling partial ownership of the company
You can buy these bonds and receive a known interest payment in addition to your original payment back at some point in the future. You can also buy stocks instead for an ownership stake in the company and possibly get dividend payments in the future.
If the company goes bankrupt, their assets will be liquidated or sold off and the money will be used to pay off the bondholders first before the stockholders. In addition, there is no guarantee what price you will be able to sell the stock at in the future.
Therefore, you have a likelihood of receiving your principle investment plus interests when you buy a company’s bonds which makes them relatively less risky than buying that company’s stocks.
Risk free rate
Section titled “Risk free rate”The risk-free rate of return is a theoretical benchmark in finance, representing the expected return on an investment with no risk of financial loss. In practical terms, it is often associated with highly secure government securities, such as the three-month U.S. Treasury bill, thought to carry minimal risk due to the low likelihood of government default.
Stocks are risky
Section titled “Stocks are risky”The stock market is risky because there is no guarantee that tomorrow you will be able to sell your stocks at the same or higher price than you bought it today.
If it had the same expected return as the U.S. Treasury bill then a rational investor has no reason to put money in the stock market other than the thrill of getting on the roller coaster of ups and downs.
So to make it worthwhile to invest in the stock market, the expected returns must be higher than the risk free rate. So the rational investor must expect higher returns in order to invest in the stock market. It’s important to understand that this is not a guarantee of higher returns.
Capital Asset Pricing Model
Section titled “Capital Asset Pricing Model”The higher expected returns of stocks based on volatility as a measure of riskiness is the basis for the Capital Asset Pricing Model.
Ra = Rf + βa (Rm - Rf)
The expected return of an asset is the risk free rate plus the volatility of a stock relative to the market times the market risk premium.