What Is Market Risk Premium?
The market risk premium (MRP) represents the additional return above the risk-free rate that investors demand for choosing a risky market portfolio.
MRP is depicted as the slope of the Security Market Line (SML) and stems largely from the Capital Asset Pricing Model (CAPM). This model measures the required rate of return on equity investments and is fundamental to modern portfolio theory and discounted cash flow valuation.
Key Takeaways
- The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate.
- It quantifies the extra return required by market participants for assuming additional risk.
- MRP is visualized as the slope of the Security Market Line (SML) in CAPM.
- Unlike equity risk premium, MRP is broader, encompassing diverse asset classes beyond just stocks; hence, equity risk premium often reflects a higher figure.
Understanding the Market Risk Premium
Market risk premium underscores the relationship between asset portfolio returns and treasury bond yields. It articulates the necessary compensation for investors factoring in both risk and opportunity costs. The risk-free rate serves as a theoretical interest rate devoid of risk, often proxied by long-term U.S. Treasury yields due to their low default risk.
Equity market returns hinge on the expected returns of indices such as the S&P 500 or the Dow Jones Industrial Average (DJIA), with real equity returns fluctuating based on the performance of underpinning businesses. Historically, the anticipated long-term return rate approximates 8% annually, though this evolves with economic cycles.
Calculation and Application
To calculate the market risk premium, subtract the risk-free rate from the expected market return. This provides a measurable differential for the extra return investors demand over the risk-free investment rate.
For instance, from 1926 to 2014, the S&P 500 demonstrated a 10.5% compounded annual return while the 30-day Treasury bill showed a 5.1% compounded return, resulting in an MRP of 5.4%. This figure feeds essential calculations in CAPM and can be employed as a supporting variable in discounted cash flow valuations.
Differentiating Market Risk Premium and Equity Risk Premium
While MRP spans the broader asset universe (stocks, bonds, real estate), the equity risk premium (ERP) solely considers stock market returns in excess of the risk-free rate. Owing to its diversification, MRP is typically less than ERP.
Historical Market Risk Premium Figures
In the U.S., the MRP has averaged around 5.5% in recent years, with historical estimates variating between 3% and 12%.
Common Risk-Free Rate Measures in MRP Calculations
In the United States, shorter-term Treasury yields, such as the 2-year Treasury, frequently serve as a viable risk-free rate proxy.
The Bottom Line
The market risk premium, illustrated by the SML’s slope, differentiates the expected market portfolio return from the risk-free rate, proffering a metric for additional returns demanded by investors for bearing higher risks.
Related Terms: equity risk premium, CAPM, security market line, risk-free rate.
References
- Statista. “Average market risk premium in the United States”.
- Aswath Damodaran. “Equity Risk Premiums: Determinants, Estimation, and Implications—The 2021 Edition”, Pages 30-35.
