What is Market Risk Premium?
The Market Risk Premium is the return investors earn (or expect to receive) by investing in risky assets rather than risk-free assets on the market. This is the premium on market risk. Those who take on riskier ventures are rewarded higher returns. The added risk premium an investor should expect in exchange for taking a risk on cutting a loss if things go wrong.
Understanding Market Risk Premium
The market risk premium is basically an element of the Capital Asset Pricing Model (CAPM), that is used by financial experts to determine an investment's level of return. The concepts of risk (volatility of returns) and compensation are at the heart of the CAPM (rate of returns). The best possible rate of return paired with the lowest available level of volatility is always preferred by investors.
Here, the formula is given below:
Market Risk Premium = Expected Rate of Return – Risk-Free Rate
Investors would first determine the risk-free rate of return before calculating the risk premium. The proportion of gains or losses that an investor predicts from a given investment is referred to as the estimated return, or expected return.
The market risk premium influences the element of uncertainty, and as a result, the risk premium varies based on the asset getting invested in. Money and cash-like products, as well as treasury securities, are considered low-risk investments, whereas stocks and high-yield debts are indeed the riskiest.
Practical Example
The JK fund had a 20% return on investment in the past. A government bond, on the other hand, had a return rate of 13%. As a result, 20% - 13% = 7%. That indicates that investors who are confident to confront the risk of investing in the X fund can expect to receive 7% more in return if they invest in a risk-free fund.
In a Sentence
- The term market risk premium is basically a financial term that indicates the difference between the expected rate of return and the risk-free rate.
- The market risk premium is commonly used in financial management to determine and calculate various assets and investments risks and returns.