Liquidity risk premium in costing of equity capital

Abstract

Return-on-equity (R-o-E) is a broadly adopted financial performance measure used to comparatively assess financial returns on equity deployed, providing a consistent revenue measure across different risk enterprises. This paper reviews some of the assumptions inherent in modern financial theory which underlie the use of R-o-E metrics. One key to such an hypothesis is an assumed ergodic behaviour of the risk enterprise. A failure of ergodic behaviour to hold leads to a required adjustment to the R-o-E metric in order to circumvent pro-cyclical risk consequences.