What Is The Market Risk Premium?

The market risk premium refers to the spread between the expected return from an equity market and the return on risk free investments. The market risk premium represents the excess return investors may receive as a reward for taking on risk.

How To Calculate Market Risk Premium

To demonstrate how to calculate market risk premium, we will be using hypothetical, non currently accurate figures. Let us suppose that the S&P 500 is compounding annually at 8%. At the same time, the 10 year treasury yield – the risk free rate – is yielding 3%. by subtracting 3% from 8%, investors would conclude that the market risk premium is 5%.

Market Risk Premium = Expected Market Return – Risk Free Rate

Applications Of Market Risk Premium

Intelligently calculating market risk premium is a vital first step for several more in depth financial equations. Such as cost of equity which is the required rate of return. Cost of equity is calculated using an equation which includes market risk premium. Cost of equity can be taken a step further and is often used as a discount rate.

Market Example

Let’s assume that the current risk-free rate of return is 3%, and the expected return on the broad stock market is 10%. Based on this information, we can calculate the market risk premium as the difference between the expected return on the market and the risk-free rate of return:

Market Risk Premium = Expected Return on Market – Risk-free Rate of Return

Market Risk Premium = 10% – 3%

Market Risk Premium = 7%

This means that investors expect to receive a premium of 7% for investing in the stock market compared to investing in risk-free assets such as Treasury bonds.

The market risk premium is a measure of the additional return that investors require for taking on the risk of investing in the stock market. It represents the excess return that investors demand over and above the risk-free rate of return to compensate for the risk of investing in stocks.

In practice, the market risk premium can vary over time depending on various factors such as economic conditions, geopolitical events, and investor sentiment. The market risk premium can also differ across different markets and asset classes.

Understanding the market risk premium is crucial for investors as it helps them evaluate the potential returns and risks of investing in the stock market. It is used in various financial models such as the capital asset pricing model (CAPM) to determine the required rate of return on an investment.

Market Risk Premium