Market Risk Premium
AdvancedThe market risk premium is the extra return investors expect from holding a broad market portfolio of shares, rather than risk-free assets, calculated as the expected market return minus the risk-free rate.
The market risk premium is a key input in the Capital Asset Pricing Model, where it is multiplied by an investment's beta and added to the risk-free rate to estimate the investment's expected return.
For example, if investors expect the stock market to return 9% a year and government bonds yield 4%, the market risk premium is 5%. A share with a beta of 1.2 would then have an expected return of 4% plus 1.2 multiplied by 5%, or 10%.
The market risk premium cannot be observed directly. Analysts estimate it from historical differences between share and bond returns, from surveys of investors and finance professionals, or from forward-looking models using current dividend yields and expected growth. Estimates commonly fall in a range of a few percentage points, and different methods can give noticeably different answers.
The term is often used interchangeably with the equity risk premium. Because valuations are sensitive to it, small changes in the assumed premium can have large effects on estimated company values.
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