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Meaning of Market Risk Premium
The additional return an investor receives for holding a risky market portfolio instead of risk-free assets is termed as a market risk premium. Analysts and investors use the Capital Asset Pricing Model (CAPM) to calculate the acceptable rate of return. Market risk premium proves to be an essential part of this CAPM.
After knowing the meaning of market risk premium, let’s have a look at the concepts used to determine the same.
Concepts Used to Determine Market Risk Premium
The following are the three concepts related to the market risk premium:
Required Market Risk Premium
The minimum amount of return the investors should accept is known as a required market risk premium. The investor will not invest if the investment’s rate of return is lower than the required rate of return. This is also termed as hurdle rate of return.
Historical Market Risk Premium
This is the term given to the measurement of an investment’s past returns. Investment instruments can be used to measure the premium delivered by the specific investment. The historical premium helps the investors in determining the performance of the investment.
Expected Market Risk Premium
The expected market risk premium is the expectation of returns an investor has from an investment.
The results of required and expected market risk premiums would vary from one investor to another. The investor performs the calculations depending on the cost of equity that is required to acquire the investment.
However, the results of historical market risk premium would be same for all investors as its calculations are based on the past performances of an investment.
On gaining an insight on concepts used to determine market risk premium, we will see the formula to calculate the same.
Market Risk Premium Formula
The formula for calculating current market risk premium is:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate
S&P 500 generated a return of 9% in the previous year, and the current rate of the treasury’s bill is 5%. The premium is 9% – 5% = 4%.
Investors are inclined towards investments having the highest possible rate of return combined with the lowest possible risk. Market risk premium is a significant element of discounted cash flow valuation and modern portfolio theory. It assists the investor in making an appropriate decision on how to gain maximum out of their investments.1