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What Is Market Risk Premium?
The difference that exists between the expected return on a marketplace portfolio and the risk free rate is termed as The market risk premium or it can also be recognized as the additional rate of return which is over and above the risk-free rate which is expected by the investors when holding up a risky investment.
Here, the term risk is defined as any investment in which there exist some risks or which is not risk free. As, there exits some risk in any investments, and you need to face risk in order to earn more on investment.
And in order to calculate market risk premium, the Capital Asset Pricing Model (CAPM) is used.
According to which or the Capital Asset Pricing Model (CAPAM) the expected return = risk free rate + Beta (return on the market – risk free rate of return)
It can also be written as follows:
Ra = Rrf + Ba (Rm – Rrf)
Where in the above Capital Asset Pricing Model (CAPAM) formula,
- Ra = the Predictable return on a security
- Rrf = the Risk free rate
- Ba = Beta of the security
- Rm = the Predictable return of the market
Note: And in this formula the Risk Premium or the market risk premium = (Rm – Rrf)
Market Risk Premium Definition
Therefore, the definition of Market Risk Premium can be termed up as the additional rate of return which is expected by the equity investors in order to reimburse for the risk of an investment.
The Market Risk Premium in CAPM
As we know that Market Risk Premium is the difference that exists by holding up investment and in the risk free rate.
So, let us understand the Capital Asset Pricing Model (CAPAM) with the help of the figure given below:
Though, we know that higher the risk gives higher or more amount of profit. So, is the case giving higher returns with a higher amount of risk? Therefore, the risk premium is the one that exists between the market return and the risk free rate in the market. And this risk premium rises with the amount of risk you take up, as higher the return you get depends upon the higher risk you are taking up. So, you can say that the Market Risk Premium depends upon the risk.
Market Risk Premium Formula
The Formula for the Market Risk Premium can be stated as follows:
- Market Risk Premium Method = The Predictable Return – Risk Free Rate
OR
- Market risk premium = The Market rate of return – the Risk free rate of return
So, we have the Market Risk Premium Formula by deducting the risk free rate of return by the market or the expected return from an investment.
How to calculate the market risk premium
So, you can calculate Market Risk Premium with the help of Market Risk Premium formula or by subtracting the risk free rate from the expected or the market return of a particular investment. Though, the formula for Market Risk Premium can be stated as follows:
- Market Risk Premium Method = The Predictable Return – Risk Free Rate
OR
- Market risk premium = The rate of return of the Market – the Risk free rate of return
Examples of market risk premium
Example 1: Taking up an example of an investor who invests in the portfolio having expected a rate of return of 14{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} and giving a return of 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} on the investments. Calculate the Market Risk Premium for the stakeholder.
Given to us in the above information:
- Expects a rate of return = 14{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Return = 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Applying the formula as
Market Risk Premium Formula = Expected Return – Risk-Free Rate
- Market Risk Premium = 14 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} – 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Market Risk Premium = 9{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Also Read:- What is Profitability Index How to Calculate it
Market Risk Premium in Excel:
Now, the above example is calculated in Excel as follows:
A | B | |
---|---|---|
1 | Particulars | Value |
2 | Expected Return | 14 |
3 | Risk-Free Rate | 5 |
Applying or using the formula =(B2-B3), for calculating the Market Risk Premium.
A | B | |
---|---|---|
1 | Particulars | Value |
2 | Expected Return | 14 |
3 | Risk-Free Rate | 5 |
4 | Market Risk Premium | 9 |
So, the investor will have a market risk premium of 9{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}.
Example 2: Taking up an example of an investor who invests in the portfolio having expected a rate of return of 20{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} and giving a return of 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} on the investments. Calculate the Market Risk Premium for the stakeholder.
Given to us in the above information:
expects a rate of return = 20{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
return = 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Applying the formula as
Market Risk Premium Formula = Expected Return – Risk-Free Rate
- Market Risk Premium = 20 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} – 10 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Market Risk Premium = 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Market Risk Premium in Excel:
Now, the above example is calculated in Excel as follows:
A | B | |
---|---|---|
1 | Particulars | Value |
2 | Expected Return | 20 |
3 | Risk-Free Rate | 10 |
Applying or using the formula =(B2-B3), for calculating the Market Risk Premium.
A | B | |
---|---|---|
1 | Particulars | Value |
2 | Expected Return | 20 |
3 | Risk-Free Rate | 10 |
4 | Market Risk Premium | 10 |
So, the investor will have a market risk premium of 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}.
Example 3: Taking up the example of two investments having return and market return as follows:
Particulars | Investment 1 | Investment 2 |
---|---|---|
Expected Return | 10 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 20 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
Risk-Free Rate | 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
Given to us in the above information:
- Expected rate of return of investment 1 = 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Return of investment 1 = 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Expected rate of return of investment 2 = 20{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
- Return of investment 2 = 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Investment 1:
Using the information and Applying the formula as
Market Risk Premium Formula = Expected Return – Risk-Free Rate
Market Risk Premium Formula = 10 – 5
Market Risk Premium Formula = 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
For Investment 2:
Using the information and Applying the formula as
Market Risk Premium Formula = Expected Return – Risk-Free Rate
Market Risk Premium Formula = 20 – 5
Market Risk Premium Formula = 15 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}
Using the Market Risk Premium Formula in Excel:
A | B | C | |
---|---|---|---|
1 | Particulars | Investment 1 | Investment 2 |
2 | Expected Return | 10 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 20 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
3 | Risk-Free Rate | 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
Market Risk Premium | =(B2-B3) | =(C2-C3) |
Using the formula for investment 1 as =(B2-B3) and for investment 2 as =(C2-C3).
A | B | C | |
---|---|---|---|
1 | Particulars | Investment 1 | Investment 2 |
2 | Expected Return | 10 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 20 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
3 | Risk-Free Rate | 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 5 {367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
Market Risk Premium | 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} | 15{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
So, from investment 1 we get the Market Risk Premium of 5{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} and from investment 2 we get the Market Risk Premium of 15{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}. So, here the rate of return is the deciding factor for calculation of the Market Risk Premium.
Interpretation of the market risk premium:
- Higher the equity market risk premium, the higher will be the risk of the investment. So, the investor will expect higher returns with higher risk.
Advantages of the market risk premium:
- It is easy to use.
- The investor has an immediate idea about the investment.
Disadvantages of the market risk premium:
- Due to its assumptions, it is extremely subjective in nature.
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Conclusion:
An investor prefers to invest in an investment having a rate of return which is high and the risk which is low. So, the Market Risk Premium helps the investor in taking up the decision of investment and gaining higher returns or profits from an investment.
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