The notion that risk matters and that riskier investments should have higher expected returns than safer investments, to be considered good investments, is both central to modern finance. Thus, the expected return on any investment can be written as the sum of the risk-free rate and a risk premium to compensate for the risk. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In effect, the equity risk premium is the premium that investors demand for the average risk investment and by extension, the discount that they apply to expected cash flows with average risk. When equity risk premia rises, investors are charging a higher price for risk and will therefore pay lower prices for the same set of risky expected cash flows.

Equity risk premia are a central component of every risk and return model in finance and is a key input into estimating costs of equity and capital in both corporate finance and valuation.