The equity risk premium (ERP), or equity premium, is the difference in expected or realized return between an equity index and a reference asset, where the latter is usually a bond or bill portfolio considered to be “riskless.” In the modern literature and in investment management practice, ERP usually means “expected ERP” and we will stick to that convention, reserving the phrase “realized ERP” for any backwardlooking or historical measure.
The ERP is widely acknowledged as the most important variable in finance. It is useful for:
- Knowing what returns to expect from each major asset class and from portfolios of securities or asset classes
- Lifecycle and retirement planning (so one can estimate how much to save and invest in the hope of achieving a given standard of living in retirement), and
- As a component of the opportunity cost of capital or required rate of return in corporate finance