What is 'Market Risk Premium'
The market risk premium is the difference between the expected return on a market portfolio and the riskfree rate. 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 required rate of return on equity investments, and it is an important element of modern portfolio theory and discounted cash flow valuation.
Market risk premium describes the relationship between returns from an equity market portfolio 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 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.
Theory
Investors require compensation for risk and opportunity cost. The riskfree rate is a theoretical interest rate that would be paid by an investment with zero risk, and longterm yields on U.S. treasuries have traditionally been used as a proxy for the riskfree 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. Real equity returns fluctuate with 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 longterm potential of approximately 8% annually. As of 2016, some economists are calling for a reduction in this assumed rate, though opinions on the topic diverge. 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 riskfree rate from the expected equity market return, providing a quantitative measure of the extra return demanded by market participants for 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, while the 30day 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 riskfree rate. This is often used as the discount rate in discounted cash flow, a popular valuation model.
BREAKING DOWN 'Market Risk Premium'

Risk Premium
The return in excess of the riskfree rate of return that an ... 
Capital Asset Pricing Model  CAPM
A model that describes the relationship between risk and expected ... 
RiskFree Asset
An asset which has a certain future return. Treasuries (especially ... 
Cost Of Equity
In financial theory, the return that stockholders require for ... 
Capital Allocation Line  CAL
A line created in a graph of all possible combinations of risky ... 
Equity Premium Puzzle  EPP
A phenomenon that describes the anomalously higher historical ...

Investing
Understanding Market Risk Premium
Market risk premium is equal to the expected return on an investment minus the riskfree rate. The riskfree rate is the minimum rate investors could expect to receive on an investment if it ... 
Investing
How to Calculate Risk Premium
Think of a risk premium as a form of hazard pay for risky investments. 
Investing
What Investors Should Know About Interest Rates
Understanding interest rates helps you answer the fundamental question of where to put your money. 
Investing
The Capital Asset Pricing Model: an Overview
CAPM helps you determine what return you deserve for putting your money at risk. 
Investing
RiskFree Rate of Return
The riskfree rate of return is the theoretical rate of return of an investment with zero risk. The riskfree rate represents the interest an investor would expect from an absolutely riskfree ... 
Managing Wealth
How Interest Rates Affect Property Values
Along with their impact on mortgages, interest rates affect capital flows, the supply and demand for capital, and an investorâ€™s required rate of return. 
Investing
The EquityRisk Premium: More Risk For Higher Returns
Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium. 
Investing
How Risk Free Is The RiskFree Rate Of Return?
This rate is rarely questioned  unless the economy falls into disarray. 
Investing
Valuation Models: Appleâ€™s Stock Analysis With CAPM
The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the assetâ€™s return.

What is the historical market risk premium?
Learn what the historical market risk premium is and the different figures that result from an analyst's choice of calculations ... Read Answer >> 
How is the expected market return determined when calculating market risk premium?
Find out how the expected market return rate is determined when calculating market risk premium and how these figures are ... Read Answer >> 
Is the market risk premium the same for stocks and bonds?
Take a look at historical equity risk premium and credit spreads in the United States, which suggest that equities carry ... Read Answer >> 
What is the correlation between equity risk premium and risk?
Learn about the relationship between the riskfree rate of return and the equity risk premium, and understand how the riskfree ... Read Answer >> 
What does a high equity risk premium signify about a company's stock future?
Learn about how a high equity risk premium affects a stock's future. These types of stocks tend to be the most volatile instruments ... Read Answer >> 
What is the formula for calculating the capital asset pricing model (CAPM)?
Learn about the capital asset pricing model, or CAPM, and how this formula is used to determine the expected rate of return ... Read Answer >>