From the course: Corporate Finance Foundations
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Equity risk premium
From the course: Corporate Finance Foundations
Equity risk premium
- An investment in the shares of a company is more risky than, say, an investment in a bank account. So there should be a higher expected rate of return. More anticipated risk, more expected return. By the way, an investment in the shares of a company is called an equity investment. You are investing in the equity or ownership of a company. Because an equity investment is more risky than a risk-free investment, there needs to be a premium associated with accepting that increased risk. We call this the equity risk premium. The equity risk premium is the extra amount you expect to earn on your investment because you are investing in risky assets. In the United States, for example, over the last 50, 60, 70 years, an investment in stocks has averaged a rate of return of about 10 or 11% per year. The historical rate of return to be expected on risk-free investments is about 5%. The difference between those two, the 5% risk-free rate, and the 11% rate on equity investments, that's called…
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