When an investor invests money, he or she works on the assumption that with the riskier the investment, the higher the possible reward. The equity risk premium equals the expected return on the market minus the risk-free rate. The risk-free rate is the interest rate an investor can earn while taking relatively no risk. Traditionally, United States Treasury Bills have been the safest investment, so most people use them as the risk-free rate.
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Determine the return on an investment. For example, a stock may offer returns at a rate of 10 per cent.
Determine the risk-free rate. The risk-free rate is normally the rate of U.S. Treasury Bonds. For example, if U.S. Treasury Bonds return five per cent, then the risk-free rate is five per cent.
Subtract the risk-free rate from the rate of return to determine the equity risk premium. In the example, 10 per cent minus five per cent equals an equity risk premium of five per cent.
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