Investors want two things: high returns and no risk. The market risk premium brings these two concepts together; it is any return over the risk-free rate. The risk-free rate is defined as the return an investor can expect on an investment with no risk, but what does this mean? Is there such a thing as an investment with no risk? If so, can you use it to find the market risk premium? The answer is yes.
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Understand the concept. Market risk premium is a function of supply and demand. When in equilibrium, there is no need to pay a premium; that is, supply is in line with demand. If demand increases, and supply cannot meet demand, the price for that asset goes up. The price difference is the premium. Market risk premium is the price difference over the risk equilibrium. How do you find the risk equilibrium?
Define risk equilibrium or the risk-free rate. The most "risk-free" asset is debt from the United States government. That is, there is very little chance that the government of the United States will default on treasuries. For this reason, the rate of return on treasuries is often used as a proxy for the risk-free rate of return. Another proxy is LIBOR (London interbank offer rate).
Determine the risk-free rate. Again, as treasuries are backed by the "full faith and credit" of the United States government, we will use the 10-year treasury as a proxy for the risk-free rate. According to the U.S. Treasury, the 10-year treasury yield is 3.84 per cent. This is your baseline. See Resources for a link to updated rates.
Determine the rate of return for the market. In the paper "The Supply of Stock Market Returns," six different methods are used to find the average market return from 1926 to 2000. The average compounded rate of return was 10.70 per cent.
Find the market risk premium. Take the difference between the average market rate of return (10.70 per cent) and the risk free rate (3.84 per cent). The market's "risk premium" is 6.86 per cent.
Tips and warnings
- The capital asset pricing model (CAPM) is a formula that uses market risk premium to calculate the expected return for any stock. The formula is Ra = Rf + b(Rp), where Ra is the return on the stock, Rf is the risk-free rate (3.84 per cent), b is beta or a measure of risk for the stock and Rp is the market risk premium. You can look up the beta for any stock on Yahoo! Finance.
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