Market Risk Premium

From CEOpedia | Management online
Market Risk Premium
See also


Market Risk Premium
See also

Market Risk Premium- is the difference between required returns and average risk assets[1]. This is one of the essential parameter of finance. It is also called equity premium or risk premium. This definition is hard to understand because it consists of a few conceptions[2]. Market Risk Premium is the main factor of asset allocation and it determines a choice of portfolio which is composite debt and equity instruments[3].

Three Conceptions of Market Risk Premium

There are these conceptions[4]:

  • The required Market Risk Premium - is the first conception that contains incremental return of a diversified portfolio over a risk- free rate which is required by investors.
  • The historical Market Risk Premium - is the second conception that contains a historical return of the stock market over treasury bonds. In this conception, a piece of information may be legitimate as interesting or not interesting.
  • The expected Market Risk Premium - is the third conception, in which the differential return of the stock market is over treasury bonds. Many authors consider that this conception with The historical Market Risk Premium and The required Market Risk Premium are identical.

Moreover, The CAPM submits that the required market risk premium is the same as the expected market risk premium. In assumptions of this conception arise that the historical market risk premium is the same for all investors but the issue of required returned market risk premium are various for individual investors[5].

Estimating of Market Risk Premium

This formula role-plays a significant role in CAPM (Capital Asset Pricing Model). In recent years estimating the risk of the market has gained after implementation by investors financial frameworks to analyze corporate performance. The Market Risk Premium mainly relied on the historical difference between a returned of stocks or bonds[6].

The Methods of estimating Market Risk Premium

The basic method to calculate is the historical return of the stock market with a return of the free-risk rate. This is a common use of historical data to compare with the return of the investment with a share of the free-risk rate. This method reflects an indicator of market premium. What is more, this method is sometimes called an Ibottson method and its assumption that in the past the expected cost of capital was equal to the actual received [7].

The Market Risk Premium is a crucial parameter that may influence to choose an appropriate portfolio. The considerable difference between required returns and average risks assets encourages to allocate a sum of money on investment enterprise. On the other hand, in terms of the investor, a portfolio with smaller spread is less cost-effective because it gives us low profits a it gives bigger risk.

References

Footnotes

  1. Harris S R. (1999), p.1
  2. Fernandez P.(2004), p.1
  3. Harris S R. (1999), p.1
  4. Fernandez P.(2004), p.1
  5. Fernandez P.(2004), p.1
  6. Harris S R. (1999), p.1
  7. Fernandez P.(2004), p.3

Author: Tomasz Kuś