What is the market risk premium?
The market risk premium (MRP) is the difference between the expected return of a market portfolio and the risk-free rate.
The market risk premium is equal to the slope of the security market line (SML), a graphical representation of the Financial asset pricing model (CAPM). CAPM measures the required rate of return on equity investments, and it is an important part of modern portfolio theory (MPT) and discounted cash flows (DCF).
Key points to remember
- The market risk premium is the difference between the expected return of a market portfolio and the risk-free rate.
- It provides a quantitative measure of the additional return demanded by market participants for the increased risk.
- The market risk premium is measured as the slope of the security market line (SML) associated with the CAPM model.
- The market risk premium is broader and more diversified than the equity risk premium, which only considers the stock market. As a result, the equity risk premium is often higher.
Understanding the Market Risk Premium
The market risk premium describes the relationship between the returns of a portfolio of assets and Treasury bond yields. The risk premium reflects required returns, historical returns and expected returns. The historical market risk premium will be the same for all investors. The required and expected market premiums, however, will differ from investor to investor depending on risk tolerance and investment styles.
Investors demand compensation for risk and opportunity costs. The risk free rate is a theoretical interest rate that is paid by a risk-free investment. Long-term US Treasury bond yields have traditionally been used as risk-free rate proxy due to the low risk of default and had relatively low returns due to this presumed reliability.
Stock market returns are based on the expected returns of a broad benchmark such as the Standard & Poor’s 500 Index of the Dow Jones Industrial Average (DJIA). Actual stock returns fluctuate with the operating performance of the underlying business.
Historical rates of return have fluctuated as the economy matures and endures cycles, but conventional knowledge has generally estimated a long-term potential of around 8% per year.
Calculation and application
The market risk premium can be calculated by subtracting the risk-free rate from the expected equity market return, providing a quantitative measure of the additional 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 posted a compound annual rate of return of 10.5%, while 30-day Treasury bills posted a compound rate of return of 5.1%. This indicates a market risk premium of 5.4%, based on these parameters.
The required rate of return for an individual asset can be calculated by multiplying the beta coefficient of the asset by the market coefficient, then adding the risk-free rate. This is often used as the discounted cash flow discount rate, a popular valuation model.
What is the difference between the market risk premium and the equity risk premium?
The market risk premium (MRP) broadly describes the additional returns above the risk-free rate that investors demand when they put a portfolio of risky assets on the market. This would include the universe of investable assets, including stocks, bonds, real estate, etc.
The equity risk premium (ERP) looks more closely only at the excess returns of stocks over the risk-free rate. Because the market risk premium is broader and more diversified, the equity risk premium itself tends to be higher.
What is the historical market risk premium?
In the United States, the market risk premium has hovered around 5.5% over the past decade. Historical risk premiums used in practice have been estimated at 12% and 3%.
What is used for the risk-free rate when measuring the market risk premium?
In the United States, the yield on government bonds such as 2-year Treasury bills is the most widely used risk-free rate of return.
The market risk premium is the difference between the expected return of a market portfolio and the risk-free rate. It provides a quantitative measure of the additional return demanded by market participants for increased risk.