diversified portfolio that should be measured and compensated. In fact, it is this view of riskthat leads us to break the risk in any investment into two components. There is a firm-specificcomponent that measures risk that relates only to that investment or to a few investmentslike it, and a market component that contains risk that affects a large subset or allinvestments. 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 whenit comes to how to measure this market risk. In the capital asset pricing model (CAPM), the
Electronic copy available at: 7 market risk is measured with a beta, which when multiplied by the equity risk premiumyields the total risk premium for a risky asset. In the competing models, such as the arbitragepricing 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 therole that equity risk premiums play in each one:Table 1: Equity Risk Premiums in Risk and Return ModelsModelEquity Risk Premium Expected Return = Riskfree Rate + BetaAsset(Equity Risk Premium)Risk Premium for investing inthemarketportfolio,whichincludes all risky assets, relativeto the riskless rate.Arbitragepricingmodel (APM)Risk Premiums for individual(unspecified)marketriskfactors.Multi-Factor ModelRisk Premiums for individual(specified) market risk factorsProxy ModelsExpected Return = a + b (Proxy 1) + c(Proxy 2) (where the proxies are firmcharacteristicssuchasmarketcapitalization,pricetobookratiosorreturn momentum)Noexplicitriskpremiumcomputation, but coefficients onproxies reflect risk preferences.All of the models other than proxy models require three inputs. The first is theriskfree rate, simple to estimate in currencies where a default free entity exists, but morecomplicated in markets where there are no default free entities. The second is the beta (inthe 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 willconcentrate 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, inthe sense that it is not company-specific or asset-specific but affects expected returns on allrisky investments. Using a larger equity risk premium will increase the expected returns forall risky investments, and by extension, reduce their value. Consequently, the choice of anequity risk premium may have much larger consequences for value than firm-specific inputssuch as cash flows, growth and even firm-specific risk measures (such as betas).