In fact it is this view of risk that leads us to

diversified portfolio that should be measured and compensated. In fact, it is this view of risk
that leads us to break the risk in any investment into two components. There is a firm-specific
component that measures risk that relates only to that investment or to a few investments
like it, and a market component that contains risk that affects a large subset or all
investments. It is the latter risk that is not diversifiable and should be rewarded.
All risk and return models agree on this crucial distinction, but they part ways when
it comes to how to measure this market risk. In the capital asset pricing model (CAPM), the

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market risk is measured with a beta, which when multiplied by the equity risk premium
yields the total risk premium for a risky asset. In the competing models, such as the arbitrage
pricing and multi-factor models, betas are estimated against individual market risk factors,
and each factor has its own price (risk premium). Table 1 summarizes four models, and the
role that equity risk premiums play in each one:
Table 1: Equity Risk Premiums in Risk and Return Models
Model Equity Risk Premium
Expected Return = Riskfree Rate + Beta
Asset
(Equity Risk Premium)
Risk Premium for investing in
the market portfolio, which
includes all risky assets, relative
to the riskless rate.
Arbitrage pricing
model (APM)
Risk Premiums for individual
(unspecified) market risk
factors.
Multi-Factor Model Risk Premiums for individual
(specified) market risk factors
Proxy Models Expected Return = a + b (Proxy 1) + c
(Proxy 2) (where the proxies are firm
characteristics such as market
capitalization, price to book ratios or
return momentum)
No explicit risk premium
computation, but coefficients on
proxies reflect risk preferences.
All of the models other than proxy models require three inputs. The first is the
riskfree rate, simple to estimate in currencies where a default free entity exists, but more
complicated in markets where there are no default free entities. The second is the beta (in
the CAPM) or betas (in the APM or multi-factor models) of the investment being analyzed,
and the third is theappropriate risk premium for theportfolio of all riskyassets (in the CAPM)
and the factor risk premiums for the market risk factors in the APM and multi-factor models.
While I examine the issues of riskfree rate and beta estimation in companion pieces, I will
concentrate on the measurement of the risk premium in this paper.
Note that the equity risk premium in all of these models is a market-wide number, in
the sense that it is not company-specific or asset-specific but affects expected returns on all
risky investments. Using a larger equity risk premium will increase the expected returns for
all risky investments, and by extension, reduce their value. Consequently, the choice of an
equity risk premium may have much larger consequences for value than firm-specific inputs
such as cash flows, growth and even firm-specific risk measures (such as betas).