DEFINITION of 'Market Risk Premium'
The difference between the expected return on a market portfolio and the risk-free rate. Market risk premium is equal to the slope of the security market line (SML), a capital asset pricing model. Three distinct concepts are part of market risk premium:
1) Required market risk premium: the return of a portfolio over the risk-free rate (such as that of treasury bonds) required by an investor;
2) Historical market risk premium: the historical differential return of the market over treasury bonds; and
3) Expected market risk premium: the expected differential return of the market over treasury bonds.
Also called equity premium, market premium and risk premium.
INVESTOPEDIA EXPLAINS 'Market Risk Premium'
The historical market risk premium will be the same for all investors since the value is based on what actually happened. The required and expected market premiums, however, will differ from investor to investor based on risk tolerance and investing styles. The market risk premium can be calculated as follows:
Market Risk Premium = Expected Return of the Market – Risk-Free Rate
The expected return of the market can be based on the S&P 500, for example, while the risk-free rate is often based on the current returns of treasury bonds.
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