Risk Premium

The risk premium is the quantification of this additional expected return. It is not the return actually realised — which may be higher or lower depending on outcomes — but the return expected on average over many periods and many investors, representing the equilibrium compensation that market pricing has established for bearing each category of risk.

The Equity Risk Premium — The Most Important Risk Premium

The equity risk premium — universally abbreviated ERP — is the additional expected return of the broad equity market above the risk-free rate, compensating equity investors for the volatility, uncertainty, and residual claim status of equity ownership relative to the certainty of risk-free government securities.

The equity risk premium equals the expected return on the equity market minus the risk-free rate.

ERP equals expected market return minus the risk-free rate.

In the CAPM framework, the equity risk premium is the market-level compensation for systematic risk — the risk that affects all assets and cannot be eliminated through diversification. For any individual security, the CAPM specifies that the required risk premium equals beta multiplied by the equity risk premium — a high-beta stock with a beta of one and a half requires one and a half times the market equity risk premium as compensation, because its returns fluctuate one and a half times as much as the market in response to systematic economic shocks.

Two approaches are used to estimate the equity risk premium — historical and forward-looking.

Historical Estimates of the Equity Risk Premium

The historical approach measures the average excess return of equities over the risk-free rate across past periods. Long-run historical data for United States equities from 1928 through 2024, as compiled in Aswath Damodaran's NYU Stern dataset, show an arithmetic average annual equity risk premium of approximately eight and a half percent over Treasury bills and seven percent over ten-year Treasury bonds. The geometric mean — which compounds returns and is the appropriate measure for long-horizon wealth accumulation — is somewhat lower, approximately six and a half percent over bills and five and a half percent over bonds. Dimson, Marsh and Staunton's global study — first published as Triumph of the Optimists in 2002 with sixteen countries from 1900, and since extended to 35 markets through 2024 in the UBS Global Investment Returns Yearbook — reports annualised real returns of 5.2 percent for world equities against 0.5 percent for Treasury bills, a global geometric equity risk premium of roughly four and a half percent, lower than the United States premium of roughly six percent over bills on the same data, because the US data reflects survivorship bias from one of the world's most successful equity markets.

Implied Estimates of the Equity Risk Premium

The forward-looking approach estimates the implied equity risk premium from current market prices — using the current S&P 500 price, expected dividends, and expected earnings growth to derive the discount rate implied by the current valuation, then subtracting the current risk-free rate. Aswath Damodaran of NYU Stern publishes monthly implied equity risk premium estimates — at the start of January 2025 the implied US ERP was approximately four point three percent, reflecting elevated equity valuations relative to historical averages but still meaningfully above zero given long-term earnings growth expectations.

Why Historical and Implied Estimates Move Apart

The historical and forward-looking approaches do not merely produce different numbers — they can move in opposite directions in response to the same market events. A historical estimate is an average of excess returns already realised, so a long advance in stock prices adds years of high returns to the record and raises it. An implied estimate is the discount rate that equates the current index level with expected future cash flows, so the same advance, with cash flow expectations little changed, lowers it. Rising prices therefore make the backward-looking estimate more generous at the very moment the forward-looking estimate becomes less so.

Damodaran's NYU Stern data show the divergence at both ends of a market cycle. Measured from 1928, the arithmetic average premium of the S and P 500 over ten-year Treasury bonds rose from about seven point one percent through 1989 to about seven point six percent through 1999, while the implied premium fell from about three point five percent at the end of 1989 to about two percent at the end of 1999, the lowest reading in his series since 1960. The 2008 crash reversed the pattern: the historical average through 2008 fell to about five point seven percent while the implied premium at the end of 2008 rose to about six point four percent.

Historical estimates are also statistically imprecise. Annual excess returns of stocks over ten-year Treasury bonds have had a standard deviation of roughly twenty-one percentage points since 1928, so the standard error of a ninety-seven-year average — the standard deviation divided by the square root of the number of years — is roughly two percentage points. A historical premium estimated at seven percent is therefore consistent, at conventional confidence levels, with a true long-run premium anywhere from about three to about eleven percent, and estimates drawn from shorter periods are less precise still.

Combining Models of the Equity Risk Premium

Because no single estimation method commands agreement, researchers at the Federal Reserve Bank of New York have combined many of them. In a 2013 review, Fernando Duarte and Carlo Rosa gathered twenty-nine widely used models of the equity risk premium drawn from four families — surveys, dividend discount models, cross-sectional regressions and time-series regressions — which together use more than thirty predictors, ranging from price-dividend ratios to inflation. They then formed a single weighted average of the models, choosing the weights so that the combined measure explains as much of the variation across the models as possible, the statistical construction known as the first principal component.

The combined measure gave a one-month-ahead equity risk premium of about five point four percent for December 2012, about as high as it had ever been, with earlier peaks in November 1974 and January 2009. Because some of the models emphasise dividends and others emphasise risk-free rates, the authors could use the difference between them to isolate what was driving the result. They traced the high reading mainly to Treasury yields that were unusually low at all foreseeable horizons, rather than to unusually high expected cash flows: current dividends were roughly at their historical average, and expected dividend growth only modestly above it. A rough counterfactual suggested that the premium would still have been well above its historical norms had Treasury yields been at normal levels.

The Equity Premium Puzzle

The size of the historical premium is itself a long-standing problem in financial economics. In 1985 Rajnish Mehra and Edward Prescott tested the restrictions that a class of general equilibrium models places on the average returns of equities and Treasury bills against United States data for 1889 to 1978, and found those restrictions strongly violated — a result they showed to be robust to the specification of the model and to measurement problems. In Mehra's later description, the historical premium of stocks over relatively risk-free Treasury bills is an order of magnitude greater than can be rationalised in the context of the standard neoclassical paradigm of financial economics, a regularity that became known as the equity premium puzzle.

The puzzle has two sides. Mehra and Prescott concluded that the equilibrium model most likely to succeed would be one that is not an Arrow-Debreu economy and that simultaneously rationalises both the historically large average return on equities and the small average return on the risk-free asset — so the difficulty lies not only in an equity return that seems too high for the model, but also in a risk-free return that seems too low for it. In a 2003 review of the research the puzzle had prompted, Mehra argued that the resolutions proposed in the intervening years fail along crucial dimensions.

The puzzle concerns explanation rather than measurement. It takes the historical record as given and asks why standard theory cannot account for a premium of that size.

The Credit Risk Premium — Compensation for Default

The credit risk premium — also called the credit spread or default risk premium — is the additional yield that a bond carrying credit risk must offer above a comparable-maturity Treasury security to compensate investors for the probability of default and the expected loss severity if default occurs.

Credit risk premium equals the yield on a risky bond minus the yield on a comparable-maturity Treasury security.

The credit risk premium is observable in real time through bond market prices. Investment grade corporate bonds — rated BBB- and above by S&P and Fitch, Baa3 and above by Moody's — typically carry credit spreads of fifty to two hundred basis points above comparable-maturity Treasuries depending on credit quality, maturity, and market conditions. High yield bonds — rated below investment grade — carry credit spreads of two hundred to eight hundred basis points or more, reflecting substantially higher default probabilities and lower expected recovery rates.

The credit risk premium fluctuates significantly with the economic cycle. During economic expansions when corporate earnings are strong and default rates are low, credit spreads compress — investors accept lower compensation for bearing default risk because the probability of that risk materialising is reduced. During recessions when earnings deteriorate and default rates rise, credit spreads widen dramatically as investors demand higher compensation for bearing risk that has become more likely to result in actual losses. The spread of Moody's seasoned Baa corporate bond yields — the lowest investment grade tier — over the ten-year Treasury yield, as published by the Federal Reserve Bank of St. Louis, averaged about one hundred and sixty basis points in the first half of 2007 and about six hundred basis points in December 2008 — nearly a fourfold increase in the compensation demanded for bearing corporate credit risk in under two years.

This procyclical widening of credit spreads has direct implications for portfolio management. A broker-dealer representative who fails to account for the possibility of spread widening when recommending corporate bond investments — particularly high yield bonds — to retail customers who cannot tolerate mark-to-market losses may fail the care obligation under Regulation Best Interest at 17 CFR 240.15l-1, which requires reasonable diligence, care and skill to understand the potential risks, rewards and costs of a recommendation and a reasonable basis to believe that it is in the particular retail customer's best interest; treating the yield spread as free income ignores the risk of spread widening and price decline.

The Excess Bond Premium

Federal Reserve economists separate the credit spread on corporate bonds into two parts. Following Simon Gilchrist and Egon Zakrajsek, the spread on each bond is first related, by regression, to the issuer's expected default risk — measured by its distance to default, an indicator based on the firm's equity valuation and leverage — and to the bond's characteristics, including its credit rating. The part of the average spread that expected default risk explains is the default-risk component; the residual is the excess bond premium.

The excess bond premium is therefore the component of corporate bond credit spreads that is not directly attributable to expected default risk. Federal Reserve economists describe it as capturing investor attitudes toward corporate credit risk — the average price of bearing United States corporate credit risk — and the Federal Reserve's Financial Stability Report describes it as derived from the residual of a regression that models corporate bond spreads after controlling for expected default losses.

Its value lies in what it predicts. In a 2016 Federal Reserve note, Giovanni Favara, Simon Gilchrist, Kurt Lewis and Egon Zakrajsek estimated that a fifty basis point increase in the excess bond premium raises the probability of a recession within the following twelve months by about fifteen percentage points, and found that the default-risk component of spreads shows no statistically significant predictive power once the excess bond premium is included. A widening of corporate spreads therefore carries different information about the economic outlook depending on which of the two components is driving it.

The Liquidity Risk Premium — Compensation for Illiquidity

The liquidity risk premium is the additional expected return demanded by investors for holding assets that cannot be quickly sold at a fair price — assets where the transaction costs, time delays, or price concessions required to convert the investment to cash are substantial relative to the investment's value.

Liquid assets — Treasury securities, large-cap equities listed on major exchanges — carry minimal liquidity risk premiums because they can be converted to cash within seconds at or near their current market value at minimal transaction cost. Illiquid assets — private equity, real estate, small-cap equities with limited daily trading volume, off-the-run bonds with few market makers — carry meaningful liquidity premiums reflecting the risk that the investor may need to sell at a material discount to fair value or may be unable to sell at all within a reasonable timeframe.

The liquidity premium is not directly observable but can be estimated by comparing the yields of otherwise equivalent securities with different liquidity characteristics — for example, the yield difference between on-the-run and off-the-run Treasury securities of the same maturity, which differs only in their secondary market trading volume and bid-ask spread width. Empirical research has estimated the liquidity risk premium in equity markets at approximately one to two percent annually for less liquid small-cap and micro-cap securities relative to highly liquid large-cap equities, though estimates vary considerably across studies and time periods.

The liquidity premium is particularly relevant for institutional investors managing portfolios that include alternative assets. A pension fund or endowment that allocates a significant portion of assets to private equity, infrastructure, or hedge funds accepts the illiquidity of those assets in exchange for the liquidity premium — the additional expected return above what liquid public market alternatives would provide. This liquidity premium is the theoretical justification for the higher expected returns targeted by illiquid alternative strategies, but it is only realisable by investors with sufficiently long investment horizons and stable liability structures that they are unlikely to be forced sellers at inopportune moments.

Liquidity Risk as a Priced Risk

The liquidity premium described above rewards the holder of an asset that is costly to sell. A distinct idea is that liquidity itself varies over time across the whole market, and that assets whose returns suffer most when market-wide liquidity dries up must offer higher expected returns. In a study circulated as a National Bureau of Economic Research working paper in 2001, Lubos Pastor and Robert Stambaugh investigated whether market-wide liquidity is a state variable important for asset pricing, and found that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity.

Their monthly measure of market liquidity is an average of individual-stock measures estimated from daily data, and rests on the principle that order flow induces greater return reversals when liquidity is lower: in an illiquid market a large purchase pushes a price further from its equilibrium value, and more of the move reverses afterwards. Over the thirty-four years they studied, the average return on stocks with high sensitivities to liquidity exceeded that on stocks with low sensitivities by seven point five percent a year, after adjusting for exposures to the market return and to the size, value and momentum factors.

The distinction matters for portfolio construction. A stock can be easy to trade on an ordinary day and still carry high liquidity risk if its returns fall sharply whenever liquidity across the market deteriorates; the premium in this framework compensates for exposure to a market-wide condition, in the same way that the equity risk premium compensates for exposure to market-wide returns rather than for an asset's own volatility.

The Maturity Risk Premium — Compensation for Duration

The maturity risk premium — also called the term premium or horizon premium — is the additional yield that longer-maturity bonds must offer above shorter-maturity bonds of the same credit quality to compensate investors for the additional uncertainty associated with extending capital for longer periods. A ten-year Treasury note typically yields more than a three-month Treasury bill not only because of expected future short-term rate changes but also because of a genuine premium for the additional duration risk, inflation risk, and opportunity cost of committing capital for ten years rather than three months.

The term premium contributes to the normal upward slope of the yield curve — longer-maturity yields exceed shorter-maturity yields when investors demand additional compensation for duration exposure. The yield curve inverts — short rates exceed long rates — when investors expect short-term rates to fall substantially in the future and when the flight-to-quality demand for long Treasuries during periods of economic stress compresses long yields below short yields despite the normally positive maturity premium.

Estimating the Term Premium

Unlike a credit spread, the term premium cannot be read directly from market prices. Economists at the Federal Reserve Bank of New York decompose Treasury yields into two components — the average of expected future short-term yields and the term premium, which they describe as the compensation investors require for bearing the risk that short-term yields do not evolve as they expected. Because expected future short rates are not observed, the split must be estimated with a model: the New York Fed's estimates, developed by Tobias Adrian, Richard Crump and Emanuel Moench, come from a five-factor, no-arbitrage term structure model fitted to zero-coupon Treasury yields, with daily estimates going back to 1961.

The estimates show that the term premium is not always positive. The ten-year term premium was negative at times in the 1960s before reverting to positive, and it was compressed, and at times negative, in the years after the 2008 crisis when short-term interest rates were close to zero. A ten-year yield above the three-month bill yield does not by itself establish a positive term premium, since expectations of rising short-term rates can produce the same upward slope.

Federal Reserve Board staff used a three-factor arbitrage-free model, set out by Don Kim and Jonathan Wright in 2005, to study the fall in long-term yields that began in the middle of 2004. The model ascribed a large portion of the decline in long-term yields and distant-horizon forward rates to a fall in term premiums, and a variant incorporating inflation data attributed about two-thirds of the decline in nominal term premiums to a fall in real term premiums, while estimated compensation for inflation risk diminished as well.

The Long-Rate Conundrum of 2004 and 2005

In testimony to Congress in February 2005, Federal Reserve Chairman Alan Greenspan observed that long-term interest rates had trended lower in recent months even as the Federal Reserve raised the target federal funds rate by 150 basis points. He noted that yields and risk spreads had narrowed globally — the German ten-year Bund yield, for example, had fallen from four and a quarter percent the previous June to about three and a half percent — so that technical factors confined to the United States could not by themselves explain the decline. For the moment, he concluded, the broadly unanticipated behaviour of world bond markets remained a conundrum.

Greenspan weighed several explanations. Heavy purchases of longer-term Treasury securities by foreign central banks had often been cited. Attempts by mortgage investors to offset a decline in the duration of their holdings by buying longer-term securities may have added downward pressure on yields. Globalisation had contributed to expectations of lower inflation in the years ahead and to lower inflation risk premiums. He found the suggestion that the decline reflected weaker expectations of economic growth hard to square with the rise in stock prices and the narrowing of credit spreads over the same period, both of which pointed the other way.

The Inflation Risk Premium

Holders of nominal bonds bear the risk that inflation will turn out different from what they expected and alter the real value of fixed payments. The Federal Reserve Bank of Cleveland describes the inflation risk premium as a measure of the premium investors require for the possibility that inflation may rise or fall more than they expect, and estimates it, together with expected inflation and a real risk premium, from a model that uses Treasury yields, inflation data, inflation swaps and survey-based measures of inflation expectations. Treasury Inflation-Protected Securities are not used in that model.

The inflation risk premium is one reason the breakeven inflation rate — the yield on a nominal Treasury security less the yield on a TIPS of the same maturity — is not a pure measure of expected inflation. Economists at the Federal Reserve Bank of San Francisco explain that, in addition to its expected inflation component, breakeven inflation is governed by two countervailing factors: the inflation risk premium, which raises nominal yields and so widens the breakeven rate, and the liquidity premium on TIPS, which raises TIPS yields because TIPS trade less readily than nominal Treasuries, and so narrows it. Because the two premiums push in opposite directions, a breakeven rate can sit above or below the inflation the market actually expects.

The same premium explains why issuing TIPS can save the Treasury money. Investors are willing to pay a premium for the protection from inflation that TIPS provide, so by issuing them the Treasury avoids paying the inflation risk premium built into nominal yields, although the liquidity discount on TIPS works against that saving. Measuring the premium conservatively, after deducting the largest plausible TIPS liquidity discount, San Francisco Fed researchers found it positive on average since 2005, which they described as an overall net gain for the Treasury.

The Country Risk Premium — Compensation for Sovereign Risk

The country risk premium is the additional expected return demanded by investors for allocating capital to investments in countries with elevated political, economic, regulatory, or sovereign credit risks relative to the most creditworthy developed markets, against which the base equity risk premium is measured. Emerging markets and frontier markets carry country risk premiums above the US market equity risk premium, reflecting risks including currency instability, capital controls, expropriation, political discontinuity, regulatory unpredictability, and — in the most extreme cases — sovereign debt default.

Aswath Damodaran's country risk premium framework quantifies these premiums by country and updates them annually from sovereign credit ratings and sovereign credit default swap spreads, scaled up for the greater volatility of equity markets than of government bonds. Countries with stable institutions, rule of law, and investment-grade sovereign credit ratings carry small or zero country risk premiums. Countries with histories of political instability, currency crises, or sovereign default carry substantial premiums of five percent or more above the base equity risk premium.

How Country Risk Premiums Are Estimated

Damodaran's published country risk premiums begin with a default spread for each country. He takes the country's local-currency sovereign rating from Moody's — or, for a country without a Moody's rating, the Moody's equivalent of its rating from another agency — and assigns it the default spread for that rating, computed as the average sovereign credit default swap spread of countries carrying that rating and extrapolated to ratings for which no such spreads exist.

Adding that default spread to a mature market premium is the standard practice, but Damodaran adds a further step, on the reasoning that the equity country risk premium is likely to exceed the country's default spread, especially in the short term. He multiplies the default spread by the relative volatility of equities and government bonds — the standard deviation of a country's equity market divided by the standard deviation of its government bonds — and, because government bonds are not available or traded in most countries, approximates that ratio with the standard deviations of an emerging market equity index and an emerging market government bond fund, applying the same ratio to every country.

The resulting country risk premium is added to the mature market equity risk premium. In his January 2026 table the mature market premium is four point two three percent and the volatility ratio is about one point five two: Brazil, rated Ba1, carries a default spread of two point one three percent, a country risk premium of three point two four percent and a total equity risk premium of seven point four seven percent, while Aaa-rated countries such as Germany and Australia carry no country risk premium at all.

Market-Based Spreads and the United States as a Reference Market

For a subset of countries a second measure of the default spread is available: the country's own sovereign credit default swap spread. Beside each rating-based figure, Damodaran publishes an equity risk premium built from that market spread instead. For Brazil in January 2026, a sovereign credit default swap spread of two point two one percent gives an equity risk premium of seven point five nine percent, close to the rating-based seven point four seven percent; where a country's market spread and its rating diverge, the two estimates diverge with them.

The United States no longer serves as a costless reference point in this framework. After Moody's downgrade of the United States, Damodaran treats the US Treasury bond rate as containing a default spread: the riskfree rate in US dollars is the Treasury bond rate minus the default spread for the United States, and the mature market premium is the US equity risk premium minus that same default spread. With the United States rated Aa1, his January 2026 table assigns it a default spread and a country risk premium of zero point two three percent, so its total equity risk premium of four point four six percent sits above the mature market premium of four point two three percent.

Risk Premium in the CAPM and Cost of Capital Calculations

The CAPM assembles all systematic market risk into a single risk premium — beta multiplied by the equity risk premium — that produces the total required return on any individual security above the risk-free rate. In corporate finance and investment analysis, the CAPM-derived required return serves as the cost of equity component of the weighted average cost of capital, which is the discount rate applied to future cash flows in discounted cash flow valuation models.

The WACC — discussed in the Weighted Average Cost of Capital entry of this dictionary — combines the after-tax cost of debt with the CAPM-derived cost of equity, weighted by the market value proportions of each in the capital structure. Because the risk-free rate and the equity risk premium enter the CAPM formula to produce the cost of equity, changes in either variable directly affect the WACC and therefore the present value of all future corporate cash flows and equity valuations. An increase in the equity risk premium — as occurs during periods of financial market stress when investors demand higher compensation for bearing market risk — raises the discount rate, reduces present values, and produces lower equity valuations even when the underlying earnings streams are unchanged.

Risk Premiums in Federal Reserve Financial Stability Monitoring

The Federal Reserve tracks risk premiums as indicators of asset valuation pressure in its Financial Stability Report, published twice a year. Its estimate of the equity premium is the difference between the forward earnings-to-price ratio of S and P 500 firms, based on earnings expected over the next twelve months, and the expected real ten-year Treasury yield — which the report describes as a measure of the additional return that investors require for holding stocks relative to risk-free bonds.

In its April 2025 report the Federal Reserve noted that, as of March, its estimate of the equity premium was near a twenty-year low and well below its historical median, and that prices remained high relative to fundamentals across a range of markets. The same report described a model-based nominal Treasury term premium — a measure of the compensation that investors require to hold longer-term Treasury securities rather than shorter-term ones — as near its longer-term historical median, and placed the excess bond premium near its long-run average.

Examination Relevance and Key Takeaways

Risk premium is tested on the Series 65 examination in the context of the CAPM, bond yield spreads, portfolio construction, the equity risk premium, credit spreads, and the fiduciary obligation to assess whether client portfolios provide adequate risk-adjusted compensation.

The key points to retain are these.

A risk premium is the additional expected return above the risk-free rate that investors demand as compensation for bearing specific investment risks. Risk premiums exist because investors are risk-averse — they require higher expected returns to accept uncertainty rather than certainty. The four primary risk premium categories are the equity risk premium — excess return of the stock market above the risk-free rate, estimated at approximately four to five percent historically on a geometric basis from the Dimson Marsh Staunton global study and implied at approximately four point three percent for the US market at the start of January 2025; the credit risk premium — the yield spread of a risky bond above a comparable-maturity Treasury, reflecting default probability and expected loss severity, observable in real time through bond market prices; the liquidity risk premium — additional return for holding illiquid assets, estimated at approximately one to two percent for equity illiquidity and substantially higher for alternative assets; and the maturity risk premium — additional yield for extending duration, contributing to the normal upward slope of the yield curve.

In the CAPM, the total required risk premium for any security equals beta multiplied by the equity risk premium — the market-level compensation for systematic risk scaled by the security's sensitivity to that risk. Country risk premiums add to the base equity risk premium for investments in markets with elevated political, economic, and sovereign credit risks above a mature-market baseline. Rising equity risk premiums increase the discount rate applied to future cash flows in DCF models, reducing present values and producing lower equity valuations — connecting risk premium changes directly to asset price movements and the investment analysis obligations of advisers under the fiduciary duty of the Investment Advisers Act of 1940 and the care obligation of Regulation Best Interest at 17 CFR 240.15l-1.