What is Market Risk Premium?
In short:
The market risk premium represents the additional amount of return an investor expects to be compensated for holding riskier investments than risk-free investments. Market risk premium is the difference between the expected return on the market portfolio (such as S&P 500) and the risk-free rate. Knowing the market risk premium is a fundamental part of investment valuation.
From a more intuitive standpoint, an investor should logically expect to earn a higher return for taking on additional risk from an investment. The market risk premium is quantified as the additional return an investor should expect from investing in a market portfolio instead of a risk-free investment. From this point, the investor can then adjust this return to fit the risk profile of an individual investment by using a risk/return model such as the Capital Asset Pricing Model (CAPM). The formula for calculating the market risk premium is below:
FORMULA:
In-depth:
The concept behind market risk premium is relatively intuitive. An investor expects additional return for additional risk beyond the lowest possible risk investment they can make. The lowest risk investment an investor can make is in a risk-free investment such as government bills or bonds (the difference between bill and bond is the duration of investment, bonds being longer). The difference between the risky investment portfolio and the risk-free investment portfolio is therefore the market risk premium.
Market Risk Premium Simple Example
Say an investor is looking to calculate market risk premium in order to later calculate the expected return on an individual investment. For the expected market return, they decide to use the return of the S&P 500 index from the mid-1920s until 2020 which is about 10%. At the time of their calculation, the risk-free rate was .9% for the US 10 Year Treasury Note. They choose the US 10 year as the risk-free rate since the duration of the note was similar to the length of their expected investment. Calculating their market risk premium would be as follows.
Market Risk Premium = 10% – .9%
Market Risk Premium = 9.1%
Factors that affect Market Risk Premium
Three major factors will affect the market risk premium:
#1 Time period used
The time period for calculating the average return of the market will greatly influence the value you get. For example, the long-term average of the S&P 500 from 1928 until 2020 is around 10% but the return from 2008 until 2020 is around 12%. This difference while at face value seems small but can be the difference between seeing a company as fairly valued or overvalued.
#2 Choice of risk-free security used
Knowing the length of the investment the investor is going to make is very important when selecting the best risk-free rate instrument to use. Normally longer-term risk-free rates are higher than shorter-term rates, this makes intuitive sense since the investor would be locking their money up for a longer period of time. Since the future is unknown, the investor seeks to be compensated for some of the possible upside opportunity loss they may be taking.
In terms of the market risk premium impact, consider the yield of a 3-month T-bill vs the US 10 year at the time of this article’s writing. The 3-month T-bill was yielding .09% where the US 10 year was 1.10%. This clearly makes a meaningful impact on the market risk premium calculation. It is better to use a risk-free rate with a similar timeframe to your expected time invested timeframe.
#3 How the average is calculated
The last of the points of consideration for the market risk premium is the way the average is calculated, namely arithmetic vs geometric. Using a geometric average will take into consideration the effect of compounding over time while the arithmetic is the simple mean over the period of time being considered.
There are arguments to be made for the use of either type of average. However, it is most usual to use the arithmetic average when looking to calculate the return for the next year.
Quick application
In conclusion, market risk premium is a straightforward but important concept. There are possible nuances that understanding could enable an investor to be more savvy. For general quick application, an investor could normally start with an expected market return around 10% and use the US 10 year as the risk-free rate. From there they should refine their calculation based on their application.