FIN.5:4.2 - Build the risk-free return and market premium

Obtain a default-free benchmark in the cash-flow currency at the valuation date. Its maturity or term structure should match the cash-flow horizon: a short bill repeatedly rolled over does not fix a long-term return. Where maturity differences matter, use the relevant zero-coupon curve and dated discount factors. A government yield containing material default risk needs an explicit adjustment or another supported benchmark. Real cash flows need a real return basis. The risk-free-rate explanation develops these matching choices.

Choose an equity premium for the same market and benchmark convention. A historical estimate compares equity total returns with the specified risk-free returns over a stated period; the period and averaging convention affect it. An implied estimate solves for the return consistent with the current market price and forecast distributions, then subtracts the matched risk-free return. It depends on the forecast and pricing model. Compare defensible estimates when the choice matters; a historical average is not an observed future premium. The estimation discussion explains the trade-offs.