The market risk premium is the additional return that an investor will get or expect to get from holding a risky portfolio.
The market risk premium is part of the Capital Asset Pricing Model (CAPM), which analysts and investors use to calculate an acceptable rate of return for investments. The CAPM considers both volatility, or how much returns vary over time, and expected rates of returns to determine if a given investment might be too risky or not rewarding enough compared with other options. Investors always prefer having the highest possible rate combined with the lowest possible volatility when it comes to investing their money.
How To Calculate Market Risk Premium
Here is the formula to calculate Market risk Premium:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate.
The S&P 500 generated a 9% return from the previous year, and the recent interest rate of the Treasury bill is 5%. The premium is 9% – 5% = 4%.
Concepts For Determining Market Risk Premium
Below are the 3 primary concepts related to determining the premium:
Required market risk premium
It is the minimum amount that investors should accept. Well, if an investment’s rate of return is lower than the required rate, then you should not consider investing. This type of method is called hurdle rates or required market risk premium (RMRP).
Historical market risk premium
A historical market risk premium is a measurement of the past return’s investment performance that is collected from an investment instrument determining the current price for all investors.
Expected market risk premium
It is based on the investor’s return expectation.
An investor’s required and expected market risk premiums differ from one another because the cost in which it takes to acquire an investment needs to be taken into consideration during calculation.
The historical market risk premium is the return that an analyst calculates by using a particular instrument. Most of the analysts use S&P 500 as their benchmark for calculating past performance because of its long history and reliability.
“A government bond” is usually the best tool for identifying a risk-free rate of return because it has little or no risk.
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