Last editedDec 20202 min read
Risky moves in finance may seem like a bad idea for most, but sometimes there is more to gain if you are willing to live a bit dangerously. Find out everything you need to know about market risk premium.
Market risk premium definition
The market risk premium is the rate of return on a risky investment. The difference between expected return and the risk-free rate will give you the market risk premium. The market risk premium is used by investors who have a risky portfolio, rather than assets that are risk-free. It is part of the Capital Asset Pricing Model which is used to work out rates of return on investments. Ideally, an investment gives a high rate of return with low risk, but sometimes taking a risk can earn bigger rewards.
Types of market risk premium
There are several areas that need to be considered when determining overall market risk premium:
Historical market risk premium
The return’s past performance is used to determine the premium. This can vary depending on which instrument is used. Generally, the S&P 500 is used as a benchmark for understanding past performance.
Required market risk premium
This is the minimum rate of return that investors should look for, sometimes known as the hurdle rate of return. If this is too low, investors are unlikely to invest. This will change from investor to investor.
Expected market risk premium
Based on expectations, the expected market risk premium will also change depending on the investor.
Other forces can impact market risk premium. For example, market risk premium UK calculations may also want to consider economic events like Brexit.
What does market risk premium impact most?
The level of risk, and therefore the market risk premium, will vary depending on the sort of asset that is being invested in. Generally, cash and cash-like instruments and government bonds are considered very low risk, while equities and high-yield debt are the riskiest options.
How to calculate the market risk premium
The calculation for finding the market risk premium is as follows:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate
For example, the X fund has a historical performance of 10% return. Meanwhile, a government bond had a return rate of 2%. So, 10% - 2% = 8%. That means investors who are willing to take the risk of investing in the X fund can expect 8% greater returns than a risk-free investment.
Is the market risk premium guaranteed?
Definitely not. Every investment has its ups and downs and while the market rate premium is able to offer guidance based on past performance, it should not be viewed as a way of absolutely predicting future performance.
What is the difference between risk premium and market risk premium?
The market risk premium refers to additional return that you make on investments that aren’t risk-free. The risk premium, also known as the equity risk premium, is used to refer to stocks, and the expected return of stock that is above the risk-free rate.
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