Market Risk Premium

From CEOpedia | Management online

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.

Examples of Market Risk Premium

  • Market Risk Premium (MRP) is the additional return, or premium, that an investor demands for investing in a risky market, such as stocks, rather than in a risk-free asset, such as government bonds. The MRP is based on the average return of all assets in the market, minus the return of the risk-free asset. MRPs are typically estimated by subtracting the expected return of a risk-free asset, such as a government bond, from the expected return of a portfolio that reflects the overall market.
  • For example, an investor might expect a 10-year Treasury bond to return 4% over the next 10 years. The investor might then estimate that a portfolio that reflects the overall stock market will return 8%. The market risk premium in this scenario would be 4%.
  • In another example, an investor might expect a 5-year Treasury bond to return 3% over the next 5 years. The investor might then estimate that a portfolio that reflects the overall stock market will return 7%. The market risk premium in this scenario would be 4%.
  • Another example would be an investor expecting a 10-year government bond to return 3% over the next 10 years and a portfolio that reflects the overall stock market to return 10%. The market risk premium in this scenario would be 7%.

Advantages of Market Risk Premium

The market risk premium is an important tool for investors to gauge the potential returns from their investments. The following are some of the advantages of using the market risk premium:

  • It provides investors with an objective measure of the expected return on investments. It is based on historical market data and can be used to compare different investment opportunities.
  • It encourages investors to diversify their portfolios, as it provides a benchmark for assessing the risk associated with different investment options.
  • It allows investors to make more informed decisions about their investments by helping them to understand the potential risks and rewards associated with different investments.
  • It can be used to determine an appropriate level of diversification, by helping investors to determine the optimal mix of investments to maximize their returns.
  • It helps investors to identify and avoid investments that may be too risky for their risk tolerance.
  • It provides investors with a reliable measure of the expected return on their investments, which can help them to make better investment decisions.

Limitations of Market Risk Premium

The Market Risk Premium (MRP) is an estimate of the additional return an investor should expect to earn due to taking on greater risk by investing in the stock market, as opposed to a risk-free asset such as a US Treasury Bond. However, there are several limitations to the MRP that should be considered when using this measure of expected return.

  • The MRP is an estimate, which means it is subject to errors and is not a precise measure. Additionally, the MRP is an average of historical returns, which may not reflect future returns.
  • The MRP does not take into account individual factors such as an investor’s risk tolerance, time horizon, or liquidity needs, which all play a role in determining an individual’s desired rate of return.
  • The MRP does not account for any other sources of return, such as dividends or interest income, which can add significant returns for certain investments.
  • Lastly, the MRP does not capture any other risks that may be associated with certain investments, such as liquidity risk or regulatory risk.

Other approaches related to Market Risk Premium

Other approaches related to Market Risk Premium:

  • CAPM (Capital Asset Pricing Model): This is a model that uses the return of the market portfolio and a risk-free rate to measure the expected return of any individual asset or portfolio.
  • Arbitrage Pricing Theory (APT): This is a model that uses multiple factors to measure the expected return of an individual asset or portfolio.
  • Dividend Discount Model (DDM): This is a model that uses the dividend rate of an individual stock or portfolio to measure the expected return.
  • Equity Risk Premium Methodology: This is a model that uses the historical equity risk premium of the market to measure the expected return of an individual asset or portfolio.

In summary, there are several approaches related to Market Risk Premium, such as CAPM, APT, DDM, and Equity Risk Premium Methodology. Each of these models uses different factors and variables to measure the expected return of an individual asset or portfolio.


Market Risk Premium — recommended articles
Running yield — WACC — Blended Rate — Economic value of equity — Gordon Growth Model — Free cash flow yield — Net yield — Calmar Ratio — Risk-free return

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

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