The difference between the expected return of a portfolio and that on a risk-free rate is known as the market risk premium. It’s equal to the slope of the security market line (SML), which shows the relationship between CAPM with equity investments’ required rates, important in modern portfolio theory and discounted cash flow valuation.

Understanding Market Risk Premiums

The market risk premium is basically the difference between equity returns and bond yields. The historical market risk premium will remain the same for all investors since it reflects what actually happened; however, expected and required premiums vary from investor to investor based on tolerance levels of taking risks as well as their investing style preferences.

How To Determine Market Risk Premium

You can calculate the market risk premium simply by subtracting the risk-free rate from the equity market return, providing a quantitative measure of all the extra return demanded by market participants for the increased risk. After being calculated, you can use equity risk premiums in some very important calculations like CAPM.

The market risk premium is known as the extra return demanded by investors for investing in stocks instead of savings accounts and CDs. 

The S&P 500 has a 5.4% higher rate than Treasury bills from 1926 to 2014, indicating that there’s an additional risk associated with investing in the stock market rather than saving your money under a mattress or keeping it in cash equivalent investments such as savings account and certificates of deposit (CD).To calculate the rate of return for an individual asset, take its beta coefficient and multiply it by the market’s risk-free interest rate. This is often used as a discount in valuation models like discounted cash flow (DCF).

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