The equity risk premium is the difference between the expected rate of return on the stock market and the risk-free rate. In recent years the size of the premium has been the premier question relating to the cost of capital, for theorists and practitioners alike. The reason is that the observed historic premium, measured over long periods and across many stock markets, is felt to be too large. From a theoretical perspective, it is too large because it has proved to be difficult to devise a plausible theory that predicts a premium of more than about 0.5 per cent p.a. Observed historic premiums are of the order of ten times bigger; this is the ‘equity premium puzzle’. The (consumption-based) models that fail to predict observed premiums are not a minor curiosity. They ‘have formed the backbone of our understanding of economic growth and dynamic micro, macro, and international economics for close to 25 years’ (Cochrane, 1997, p. 12). From an investor's perspective, many observers doubt that equity will continue to provide a premium as large as the 6 per cent p.a. or more observed during much of the twentieth century, and they doubt that investors expected a premium of this size in the past.

A figure for the premium has to be included when the CAPM, or a multifactor model that includes the stock market return as a risk factor, is used to estimate the cost of equity.