Market Risk Premium
Candlefocus EditorThe market risk premium (MRP) is a measure of the amount of compensation an investor must receive to assume the risk of an asset or a portfolio versus a risk-free rate of return. It is the expected return over and above the risk-free rate that investors demand in order to invest in an asset. The risk-free rate of return is the rate at which a risk-free asset like a government bond would yield. MRP measures the difference between the expected return on an asset and its risk-free rate.
The market risk premium is usually calculated using the Capital Asset Pricing Model (CAPM). The CAPM evaluates the expected return of any asset relative to the average return of all assets in the market portfolio. The slope of the result is known as the market risk premium and is shown on the security market line (SML). The SML uses the risk-free rate of return as the y-axis and the expected rate of return of the market portfolio as the x-axis, and is used to “map” the return of an asset or portfolio against its systematic risk level—also known as market risk.
The MRP is broader and more diversified than the equity risk premium, which only considers the stock market. Consequently, the equity risk premium is often higher. MRP accounts for the risk associated with both stocks and bonds, and provides investors and portfolio managers with a much more complete picture of their investments’ risks and potential returns.
In the finance industry, the MRP is a key factor in determining the cost of capital and the expected return of investments. Corporate treasurers and portfolio managers factor in the MRP when assessing the potential returns of different investments.
Furthermore, the MRP also plays a large role in portfolio optimization. The MRP allows investors and financial professionals to understand how much additional return they would need to receive in order to invest in riskier assets. This can help them decide which assets to include in a portfolio and how to allocate their funds.
In summary, the market risk premium is a measure of the extra return demanded by investors for taking risks in investing. The MRP is wider and more diversified than the equity risk premium, provides investors and portfolio managers with a more complete view of their investments, and plays an important role in portfolio optimization.