Market Risk Premium
Definition of market risk premium
Market risk premium is the variance between the predictable return on a market portfolio and the risk-free rate. Market Risk Premium is equivalent to the incline of the security market line (SML), a capital asset pricing model.
There are three concepts that are a part of Market Risk Premium and used to determine the market risk premium
- Required market risk premium - the return of a portfolio over the risk-free rate (such as that of treasury bonds) required by an investor;
- Historical market risk premium - the historical differential return of the market over treasury bonds; and
- Expected market risk premium - the expected differential return of the market over treasury bonds.
The historical market risk premium will be similar for all the investors as the value is the actual value of what happened. The required risk premium and the expected market risk premium can differ from one investor to the other based on how much an investor can invest and the risks these investors can take.
How to calculate a Market Risk Premium
Market Risk Premium allows an investor to find out if the investments they are about to make are worth it based on these calculations. The formula used to calculate the Market Risk Premium is as follows:
Market Risk Premium = Expected market return – Risk-free rate
It is important to understand the concept of Market Risk Premium. It is a role of supply and demand, which when in equilibrium would not need the premium to be paid. If the demand increases, the supply also cannot meet the demand and the price of the said asset increases. The difference in the price is premium. This is called the Market Risk Premium.
Risk-free assets are the assets of the government, which is why the treasuries are used as representation for risk-free rate of return. You can then determine the risk-free rate, which can be used as the baseline. Then you can determine the rate of return for the market. The difference between the average market rate of return and risk free rate would provide you with a market risk premium. It is therefore very important to determine market risk premium when you have to make a big investment. The investment the investor can make by investing in the financial products that can have risks and they won’t have problems facing the setbacks.
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