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Market Risk Premium Definition and Example

What Is Market Risk Premium?

Market Risk PremiumThe market risk premium is the difference between the expected return on an investment and the risk-free rate.  The market risk premium is part of the Capital Asset Pricing Model (CAPM).  Analysts and investors use it to calculate the acceptable rate of return for an investment.  At the center of the CAPM is the concept of risk and reward.  Investors always prefer to have the highest possible rate of return combined with the lowest possible volatility and risk.

The market premium is the additional return an investor will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets.  Simply put, the market risk premium is the return that you earn on stocks above what you could earn by investing in government bonds. For example, if the rate of return on the market is 12% when the rate on a government bond is 4%, the market risk premium is 8%.

The premium is equal to the slope of the security market line (SML), a graphical representation of the capital asset pricing model (CAPM). CAPM measures the required rate of return on equity investments, and it is an important element of modern portfolio theory and discounted cash flow valuation.  The market premium is the difference between the expected return on a market portfolio and the risk-free rate.  It provides a quantitative measure of the extra return demanded by market participants for the increased risk. (source:investopedia)

Types of Market Risk Premium

There are several areas that should be considered when determining overall market risk premium:

  • Historical market risk premiumThe return’s past performance is used to determine the premium. This can vary depending on which instrument is used. Generally, the S&P 500 is used as a benchmark for understanding past performance.
  • Required market risk premiumThis is the minimum rate of return that investors should look for, sometimes known as the hurdle rate of return. If this is too low, investors are unlikely to invest. This will change from investor to investor.
  • Expected market risk premiumBased on expectations, the expected market risk premium will also change depending on the investor.

Other forces can impact market risk premium. For example, market risk premium UK calculations may also want to consider economic events like Brexit. In the USA, calculations may want to include the outcome of a pending presidential election.

Risk-Free Rate of Return

The risk-free rate is the rate of return you could earn for not taking any risk at all. The market risk premium is intended to represent additional compensation for taking a risk.  Therefore, there needs to be a practical risk-free rate to compare to.  Most investors turn to United States Treasuries.  United States Treasury securities are considered to be risk-free. This is in spite of the fact there is at least some chance that you could lose the money you invest in United States Government debt. US Treasuries aren’t completely risk-free in the truest sense of the phrase.  Nevertheless, because of the federal tax authority, there is very little chance you could lose your money.  And because the interest rate is stable and fixed, there is little risk.

Because the Federal Government has such strong taxing authority there is very little chance it would default. If the Federal Government needed to, it could just raise taxes to pay its debt obligations. That really rolls off the tongue doesn’t it? Yes, there are a host of economic issues tangled up in that, but the relevant information here is that the bondholder would be paid back.  The other significant reason we call government bonds risk-free has to do with how we define risk. In academic financial models, we often define risk as uncertainty. To the extent that an investment’s returns fluctuate, we say they are uncertain and risky. Because US Treasuries pay a stable and fixed rate of interest there is no variability, and therefore no risk. (Source:brandonrenfro)

Market Risk Premium – A Deeper Look

Market risk premium addresses the relationship between returns from an equity portfolio and treasury bond yields. The risk premium reflects the required returns, historical returns, and expected returns. The historical risk premium will be the same for all investors.  This is because the value is based on what actually happened. However, the required and expected market premium will differ from investor to investor.  This is because they are based on risk tolerance and individual investing styles.

To recap, the market risk premium is part of the Capital Asset Pricing Model. In the CAPM, the return of an asset is the risk-free rate, plus the premium, multiplied by the beta of the asset. The beta is the measure of how risky an asset is compared to the overall market. The premium is adjusted for the risk of the asset.  For example, an asset with zero risks would have a corresponding beta of zero.  As a result, it would have the market risk premium canceled out. On the other hand, a highly risky asset, with a beta of 0.9, would take on 90% of the full premium.  At 2.0 beta, the asset is 200% or twice as volatile as the market.

Market Risk Premium – Theory

Investors require compensation for risk and opportunity cost. The risk-free rate is a theoretical interest rate that would be paid by an investment with zero risks.  The long-term yields on U.S. Treasuries have traditionally been used as a benchmark for the risk-free rate.  This is because of their stable returns combined with the low default risk. However, treasuries have historically had relatively low yields as a result of this assumed reliability. Equity market returns are based on expected returns on a broad benchmark index.  Two common reference indexes are the Standard & Poor’s 500 Index and the Dow Jones industrial average.

Real equity returns fluctuate with the operational performance of the underlying business.  As a result, the market pricing for these securities reflects this fact. Historical return rates have fluctuated as the economy matures and endures cycles.  But, conventional wisdom generally estimates a long-term potential target of approximately 8% annually. Investors demand a premium on their equity investment return relative to higher risk alternatives.  This is because their capital is more exposed to market variance. It is this additional risk exposure that leads to the equity risk premium.

Determinants for Market Risk Premium

There are three primary concepts related to determining the premium:

  • Required market risk premium – The minimum amount investors should accept. If an investment’s rate of return is lower than that of the required rate of return, then the investor will not invest. It is also called the hurdle rate of return.
  • Historical market risk premium – A measurement of the return’s past investment performance taken from an investment instrument that is used to determine the premium. The historical premium will produce the same result for all investors, as the value calculation is based on past performance.
  • Expected market risk premium – This is based on the investor’s return expectation.

The required and expected market premiums differ from one investor to another. During the calculation, the investor needs to take the cost that it takes to acquire the investment into consideration.  With a historical risk premium, the return will differ depending on what instrument the analyst uses. Most analysts use the S&P 500 as a benchmark for calculating past market performance.  Usually, a government bond yield is an instrument used to identify the risk-free rate of return.  This is because treasuries are considered to have little to no risk.

Source:corporatefinanceinstitute

Market Risk Premium Formula & Calculation

The formula is as follows:

Market Risk Premium = Expected Rate of Return – Risk-Free Rate

Example:

The S&P 500 generated a return of 7.8% the previous year.  The current interest rate of the US Treasury bill is 3.1%. The premium is 7.8% – 3.1% = 4.7%.

Risk Premium and Discount Rate

The return can be calculated by subtracting the risk-free rate from the expected equity market return.  This provides a metric for the extra return demanded by market participants for the increased risk. Once calculated, the equity risk premium can be used in important calculations such as CAPM. Between 1926 and 2014, the S&P 500 exhibited a 10.5% compounding annual rate of return.  During the same period, the 30-day Treasury bill compounded at 5.1%. This indicates a risk premium of 5.4%, based on historical parameters.

The required rate of return for an individual asset can be calculated by multiplying the asset’s beta coefficient by the market coefficient.  Then, add back the risk-free rate. This is often used as the discount rate in discounted cash flow, a popular valuation model.

Up Next: What are Common Size Financial Statements?

Common size financial statements display items as a percentage of a common base figure, total sales revenue, for example. This type of financial statement allows for easy analysis between companies, or between periods, for the same company. However, if companies use different accounting methods, any comparison may not be accurate.

A common size financial statement displays entries as a percentage of a common base figure rather than as absolute numerical figures. Common size statements let analysts compare companies of different sizes, in different industries, or across time in an apples-to-apples way. Common size financial statements include the income statement, balance sheet, and cash flow statement

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