What is the equity risk premium defined as in the material?

• A. The dividend yield on equities.
• B. The capital growth rate on equities.
• C. The excess return of equities over the risk-free rate.
• D. The correlation between equities and bonds.

Answer: (C)

The equity risk premium is the extra return investors expect for taking on the risk of owning equities versus a risk-free asset. It is defined as the excess return of equities over the risk-free rate. This premium compensates for bearing the uncertainty and volatility of stock prices and future cash flows. In models like CAPM, it helps determine expected returns by adjusting the risk-free rate upward to reflect equity risk. For example, if stocks are expected to return 8% and the risk-free rate is 3%, the equity risk premium is 5%. It’s not the dividend yield (cash income), nor the capital growth rate (price appreciation component of total return), nor a measure of how equities correlate with bonds.