Market Risk Premium
The Market risk premium Calculator helps you calculate the market risk premium effortlessly by simply inserting needed values. It is the additional return an investor receives to invest in a risky market portfolio, rather than investing in a risk-free asset. It is basically the difference between the expected rate of return commensurate with the level of risk, and the risk-free rate of return.
The formula for Calculating Market Risk Premium
As we know, there is basically a difference between the two returns. Therefore, the formula for calculating the Market Risk Premium is:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate of Return
About the Calculator / Features
In order to calculate the market risk premium with this calculator, the user simply has to provide the following data to the calculator.
- Expected rate of return
- The risk-free rate of return
How to Calculate using Market Risk Premium Calculator
To calculate the market risk premium, the user only has to provide the following data.
Expected Rate of Return
To calculate the expected rate of return, consider the following formula:
Expected Rate of Return = R1P1 + R2P2 + …. + RnPn
where R = Expected return for the given period.
P = Probability of return being achieved.
n = Number of periods.
Risk-free Rate = The prevailing rate of return for government bonds / Treasury bonds with different maturities. The analyst / investor can choose the maturity so that their requirements for calculation / analysis purposes match.
Example of Market Risk Premium
Let us understand this concept using an example: Suppose that Stock X gives a return of 7% and the risk-free rate of return is 2%. Risk-Free Rate of Return is generally the US Treasury Bonds Rate for a maturity of 7-10 years.
Market Risk Premium = 7% – 2% = 5%
Interpretation of Market Risk Premium
Analysts use the CAPM (Capital Asset Pricing Model) to calculate an acceptable rate of return. Market risk premium is an important part of this. Investors invest with the highest rate of return and the lowest risk, and this remains the ideal situation. In practical circumstances, however, this ideal rate is not always available. Therefore, an investor must take this as the reference rate. And, depending on the borrower’s risk-bearing capacity and creditworthiness, he must strive to obtain a rate of return close to this reference rate from the various available options.
It only says the additional amount that investors receive when investing in a risky market portfolio, rather than in risk-free assets. It does not say what amount investors accept for investing in risky assets, or in other words what should be acceptable to the investor or lender. Another important point is that all investment decisions are not based solely on this additional return or market risk premium. There are so many other factors that ultimately determine whether they invest or not. These are quantum of investments, investment period, return on investment, financial strength, future prospects of the business model, security of punctual payments, the status of other borrowings and thus the adequacy or excess of leverage status, and so on.