Market Risk Premium

What Is the Market Risk Premium?

The market risk premium (MRP) is the difference between the expected return on 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 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 (MPT) and discounted cash flows (DCF) valuation.

Key Takeaways

  • The market risk 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.
  • 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.
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Market Risk Premium

Understanding the Market Risk Premium

Market risk premium describes the relationship between returns from an asset portfolio and treasury bond yields. The risk premium reflects the required returns, historical returns, and expected returns. 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.

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 and long-term yields on U.S. Treasuries have traditionally been used as a proxy for the risk-free rate because of the low default risk. 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 such as the Standard & Poor's 500 index of the Dow Jones Industrial Average (DJIA).

Real equity returns fluctuate with the operational performance of the underlying business, and the market pricing for these securities reflects this fact. Historical return rates have fluctuated as the economy matures and endures cycles, but conventional knowledge has generally estimated a long-term potential of approximately 8% annually. Investors demand a premium on their equity investment return relative to lower risk alternatives because their capital is more jeopardized, which leads to the equity risk premium.

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 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% compounded annual rate of return, while the 30-day Treasury bill compounded at 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 asset's beta coefficient by the market coefficient, then adding back the risk-free rate. This is often used as the discount rate in discounted cash flow, a popular valuation model.

What Is the Difference Between the Market Risk Premium and Equity Risk Premium?

The market risk premium (MRP) broadly describes the additional returns above the risk-free rate that investors require when putting a portfolio of assets at risk in the market. This would include the universe of investable assets, including stocks, bonds, real estate, and so on. The equity risk premium (ERP) looks more narrowly 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 by itself tends to be larger.

What Is the Historical Market Risk Premium?

In the U.S., the market risk premium has hovered around 5.5% over the past decade. Historically, the risk premium has been as high as 12% and as low as 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 Treasuries are the most oft-used risk-free rate of return.

Article Sources

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  1. Statista. "Average market risk premium in the United States."

  2. Aswath Damodaran. "Equity Risk Premiums: Determinants, Estimation, and Implications—The 2021 Edition," Pages 30-35.

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