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How do you calculate it?
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In this article, we will break down the notion of Market Risk Premium so you know all there is to know about it!
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What Is The Market Risk Premium
The “market risk premium” refers to the difference between the return an investor would expect from a market portfolio and the risk-free rate.
In other words, if an investor invests in a basket of securities representing the market, the return he or she receives above the risk-free rate is considered to be the “premium” for the market risk.
The current market risk premium provides an indication as to what the market expects in premium to be paid for taking more risk than investing money in a risk-free investment.
Market participants in the United States will generally use the U.S. Treasuries returns as an approximation of what would be the return of a risk-free investment.
The long-term yields on the U.S. Treasuries will then be compared to the equity market returns based on benchmark indexes such as the S&P 500 or the Dow Jones Industrial Average.
In essence, the market risk premium represents the relationship between the returns expected from long-term treasury bonds (a proxy for the risk-free return) and broad benchmark indexes (a proxy for equity market returns).
Market Risk Premium Formula
The market risk premium formula is represented as follows:
MRP = EMR – RFR
- MRP = Market Risk Premium
- EMR = Expected Market Return
- RFR = Risk-Free Rate
Essentially, to calculate the market risk “premium”, you’ll need to subtract the risk-free rate from the expected market return.
For example, imagine that a particular investment fund offers an 8% return to investors.
If the U.S Treasuries or government bonds provide a rate of return of 1.5% at that point in time, this means that an investor investing in the fund will receive a 5.5% premium over the “risk-free return”.
Types of Market Risk Premiums
There are different types of market risk premiums to consider when evaluating an investment.
The first is the “historical market risk premium” which is to assess past performance to anticipate future performance.
For example, Standard & Poor’s past performance is used as a benchmark to understand the market performance.
You then have the “required market risk premium” representing the minimum return expected by an investor (or the hurdle rate of return).
An investor is motivated by good returns and so a higher return can better encourage investors to invest.
Then you have the “expected market risk premium” which is what an investor expects by investing in a particular way.
Capital Asset Pricing Model (CAPM)
Calculating market risk premium is an important part of the Capital Asset Pricing Model or CAPM.
Investors, analysis, and finance professionals use CAPM to calculate an acceptable rate of return on a particular investment.
An investor ideally strives for the highest possible return on an investment by taking the lowest amount of risk or assuming the lowest possible volatility on returns.
The notion of risk and reward is central to the concept of CAPM used in the modern portfolio theory and discounted cash flow valuation.
The market risk premium is equal to the security market line on the graphical representation of the capital asset pricing model.
How To Calculate Market Risk Premium
Let’s look at how an investor finds the market risk premium for a particular investment.
The first step is to determine the investor’s expected rate of return.
This evaluation has a little subjectivity to it as one investor’s risk appetite may differ from another investor.
An investor looking for high returns should accept to take a higher level of risk to achieve a higher return.
The second step is to determine what is the risk-free return in the market (market risk premium of the day).
The risk-free rate of return is what an investor can expect to receive in returns by investing in an instrument that is free of any risk (a very secure investment).
The returns offered on government bonds, treasury bills, and other long-term government bonds will provide you with a good estimation of what is the risk-free rate of return offered in the market.
In the third step and based on the MRF formula, you must deduct the risk-free rate of return from the expected rate of return demanded by the investor.
An alternative approach is to use the “market rate of return” instead of the “expected rate of return” in step two to calculate the market risk premium.
In this case, you can use a benchmark index (like the S&P 500 or other) as an approximation of the market rate of return.
Market Risk Premium vs Equity Risk Premium
What is the difference between the market risk premium and the equity risk premium?
The market risk premium is defined as the additional return investors expect when investing in a risky portfolio.
You can find the additional risk by deducting an investor’s expected return from the risk-free return on the market.
On the other hand, the equity risk premium is the excess return an investor receives by investing in the stock market as compared to the risk-free return.
You can consider the “equity” risk premium to represent the additional return offered by “equity investments” over very secure bond investments like government bonds.
Market Risk Premium Definition Takeaways
Let’s look at a summary of our findings.
Current Market Risk Premium
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Related to Financial Formulas
Book to Market Ratio
Capital Market Line
Gordon Growth Model
Market value ratios
Required Rate of Return
Security market line (SML)
Terminal Value (TV)
Times Interest Earned Ratio