Market Risk Premium

A level of risk within a market that exceeds the risk free rate

What is a Market Risk Premium?

A market risk premium is the additional return an investor will receive from holding a risky market portfolio instead of risk-free assets.

The market risk premium is part of the Capital Asset Pricing Model (CAPM) which analysts and investors use to calculate the acceptable rate of return.

Concepts Used to Determine Market Risk Premium

There are three concepts related to the market risk premium:

  1. Required market risk premium – the minimum amount investors should accept. If an investment’s rate of return is lower than that of the required rate of return, then the investor will not invest. It is also called hurdle rate of return.
  2. Historical market risk premium – a measurement of the return’s past investment performances taken from an investment instrument that is used to determine the market risk premium. The historical market risk premium will produce the same result for all investors as the value’s calculation is based on past performances.
  3. Expected market risk premium – based on the investor’s return expectation.

The required and expected market risk premiums would differ from one investor to another. During the calculation, the investor needs to take the cost of equity it takes to acquire the investment into consideration.

With a historical market risk premium, the return will differ depending on what instrument the analyst uses. Most analysts use S&P 500 as a benchmark for calculating past performance.

Usually, a government bond yield is the instrument used to calculate risk-free assets as it has minimum to no risk.

Market Risk Premium Formula & Calculation

Market Risk Premium = Expected Rate of Return – Risk Free Rate

Example:

S&P 500 generated a return of 8% the previous year, and the current rate of the treasury’s bill is 4%. The market risk premium is 8% – 4% = 4%.

Use of Market Risk Premium

As stated above, the market risk premium is part of the Capital Asset Pricing Model. In the CAPM, the return of an asset is the risk free rate plus the market risk premium multiplied by the beta of the asset. The beta is the measure of how risky an asset is compared to the market, and as such, the market risk premium is adjusted for the risk of the asset. An asset with zero risk, and therefore zero beta, for example, would have the market risk premium cancelled out. On the other hand, a highly risky asset, with a beta would 0.8, would take on almost the full market risk premium.

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