If the expected dividend return from equities is 3% per annum, the expected capital growth return from equities is 2% per annum, and the current long term Government bond yield is 2% per annum, the current equity risk premium is:

If the expected dividend return from equities is 3% per annum, the expected capital growth return from equities is 2% per annum, and the current long term Government bond yield is 2% per annum, the current equity risk premium is:

• A. 0% per annum.
• B. 2% per annum.
• C. 3% per annum.
• D. 7% per annum.

Answer: (C)

Equity risk premium is the extra return investors require for taking on stock risk over a risk-free investment. Here, the expected total return from equities equals the dividend yield plus capital growth: 3% + 2% = 5% per year. The risk-free rate is the long-term government bond yield at 2% per year. Subtracting the risk-free rate from the expected equity return gives the premium: 5% − 2% = 3% per year. So the current equity risk premium is 3% per annum.

Equity risk premium is the extra return investors require for taking on stock risk over a risk-free investment. Here, the expected total return from equities equals the dividend yield plus capital growth: 3% + 2% = 5% per year. The risk-free rate is the long-term government bond yield at 2% per year. Subtracting the risk-free rate from the expected equity return gives the premium: 5% − 2% = 3% per year. So the current equity risk premium is 3% per annum.