As Kannan stares at his portfolio in disbelief over the losses in the last two weeks, he approaches Nitin for solace. The discussion veers into equity risk premium as Kannan realises that there is another side to returns apart from earnings growth.

Kannan: The fear is palpable in equity markets right now. Even without significant earnings downgrades, stocks are retracing on fear.

Nitin: Fear, sure, but the financial term for that is higher equity risk premium and yes investors are pricing more of it.

Kannan: Please elaborate.

Nitin: Think of owning one of two equal cash flows projections, one from a proven oil well and another from a prospective oil well. Naturally, you would pay less for cash flows from the prospective oil well. This is because you associate a higher risk from this one and you want to be compensated for the riskier asset by buying at a lower price.

Mathematically, the oil well cash flows for the next twenty years are discounted to present day to arrive at a price. As risk premium increases, estimated present value of the cash flows decreases.

But the riskier oil well will be discounted by a higher risk premium compared to the proven well. As the same cash flow is discounted to the present at a higher rate, it is lower than the other, which is the price difference.

Kannan: Are equities being subjected to the same principle now?

Nitin: Yes, the price you pay for a stock has two components. The earnings or cash flows that it will generate over the years.

This is then ‘discounted’ to the present day by a discount factor that is a combination of risk free rate and risk premium. The last two weeks were more a function of equity risk premium increasing.

There will be an earnings impact for sure, but for now, investors are more focussed on the equity risk premium side of the asset pricing equation.

Kannan: Risk premium for some sectors is understandable, but this has been a multi-sector free fall.

Nitin: Risk premium is for the asset class as an entity and not specific. And theoretically speaking, you are not rewarded for specific risks in companies and sectors because you are expected to diversify away that specific risk.

Only the risk from investing in equity asset class, the risk which is over and above the safe government bonds, is what you are rewarded for. The risk premium is increasing due to uncertainty. This is the primary factor impacting equities now.

Of course, beyond what is explained, investors will have to deal with impact to earnings estimates, outlook on inflation, the rate path that central banks are likely to consider, and liquidity conditions; these are the big ticket items which are getting priced into equities. Once these factors are priced in and there is less uncertainty, the equity risk premium may start reducing again. All things remaining constant, stocks fall when equity risk premium goes up, and they move up when equity risk premium goes down.

So you can say that stocks and equity risk premium are inversely correlated.

Kannan: Now I am beginning to see. Investor perception of risk vs reward with regard to equities as an asset class is the driver for markets.

Nitin: Yes. Consider expectation of high inflation; this will erode the cash flow you earn in the future, from any sector or company.

Or if global central banks start rising interest rates again, bonds become attractive compared to equities as a whole. Or even general liquidity that will be affected which trickles down to investment vs saving. These are being priced in now.

Kannan: Got it. Not to forget, the month of April will witness earnings and most likely guidance announcements for next fiscal.

That is when earnings will start impacting equities. But then, watch out also for the equity risk premium to shrink once clarity emerges.

Published on March 7, 2026