What does the formula for historical Equity Risk Premium (ERP) involve?

The formula for historical Equity Risk Premium (ERP) focuses on the difference between historical equity market returns and the returns on a risk-free asset, typically represented by the yield on a long-term government bond, such as the 10-Year Treasury note.

When calculating the historical ERP, analysts look at historical equity returns and then subtract the historical returns of the risk-free asset over the same period. This comparison reflects the additional return that investors have historically received from investing in equities over what they could have earned from a risk-free investment.

Option B suggests that the ERP is derived from historical equity returns minus historical 10-Year return, which accurately captures this relationship by directly comparing the equity return to the risk-free benchmark that investors use to gauge the added risk of equities.

Thus, this formulation appropriately captures the concept of ERP as it reflects the additional compensation investors required for holding riskier assets, which is foundational in finance for understanding risk and return dynamics.