What is Market Risk Premium Formula, Explained with Examples
Most of us are aware of the premise that greater risk means greater return. Yet many people are unaware of the calculation to arrive at this risk. The market risk premium formula helps when considering and making investment choices.
So, how successful your investment is, depends on how you think and behave like an investor. This is where the formula of market-rate premium comes in.
Here we look at the formula, breaking it down into simple components. We then analyze them further. Thus, you’ll have a clearer idea of why the market risk premium formula is so crucial. This will help when it comes to all your financial decisions.
What is Market Risk Premium Formula?
Basically, market risk premium’s additional rate of return which is over and above risk-free rates.
The concept analyzes the relationship between risk and required return. Particularly so for that of a well-functioning market.
Thus, it determines what investors expect when holding onto that riskier of investments.
To understand the concept more, a good example is that of an individual saving in a treasury bond. This is where they except a minimum return. But, not wanting to take more risk – they receive the minimum of rates.
Now, imagine that same person wanting to take that next step from saver to investor. Looking to invest in a stock, they would perhaps expect more here in the way of return. Ultimately, they’d then expect more than what they would do by investing in treasury bonds!
This is where the concept of market risk premium comes into play.
What is the Formula for Market Risk Premium?
Surprisingly, the market risk premium formula is a simple one! But there are two methods of calculating here which investors can refer to.
This first method has easy steps to utilize, including:
- Determining an expected rate of return for an investor. This is created by their risk appetite. The higher that this risk appetite is here, the higher expected rates of return are. This is because compensation has to be made for those additional risks.
- Determining a risk-free rate of return is the expected return if the investor doesn’t take the risk. A relevant example of this is with bonds.
- The market risk premium is thus resulting from deducting risk-free rate of return from the expected rate of return.
This second method of calculating market risk premium also has easy steps to utilize.
- Firstly, the market rate of return needs determining. This is that of an appropriate benchmark indexes annual return.
- Next step is to consider a risk-free rate of return for that of the investor.
- The market risk premium is thus arrived at by deducting risk-free rate of return from that of the market rate of return.
Market Risk Premium Formula in Action Using Examples
To show how simple the market risk premium formula can be, we can look to a basic example:
An investor invests in a specific portfolio, expecting a return rate of 10% from this.
Over the last 12 months, bonds have resulted in a 4% return.
Using this information, we can calculate the formula:
Market Risk Premium = 10% – 4%
Therefore, the investors market risk premium here is 6%
Another more detailed example is where a specialist has a benchmark index. They then want to determine the figure that’s offered by the market risk premium.
The benchmark index is Y&X 300.
Growing from 700 points to 850 points throughout this year, so too the bonds have earned them a 5% average return.
Using this information, we first need to calculate what the market rate of return is using the above information:
Opening Benchmark Index: 700
Closing Benchmark Index: 860
Risk-Free Rate of Return: 5%
Market Rate of Return: 22.86%
To clarify, this figure is achieved by the calculation:
(860/700 – 1) * 100% = 22.86%
Furthermore, we can now calculate the market risk premium as follows:
22.86%- 5% = 17.86%
The Importance of Market Risk Premium
It’s highly recommended for investors of any level to gain an understanding of the notion of market risk premium. This is especially so because it relies on that critical relationship found amid risk and reward.
Thus, it’s a significant element of modern portfolio theory and discounted cash flow variation.
Ultimately, it helps the investor when making appropriate decisions. It’s also helpful when gaining the greatest out of their investments.
Understanding the Many Components involved in the Formula for Market Risk Premium
Though the formula itself is simple, several components need discussing further.
The first component here is Expected Return. This is the return that is said to be totally dependent on an investor and how they think. It’s the type of investment he or she invests in.
When looking at options from an investors point of view, we should, therefore, consider possibilities such as:
These are those investor types who are the players of the market! Understanding the ups and downs, they’re okay with the risks they need to take and go through. Yet, these investor types won’t expect much in the way of their investments. So, premiums are significantly less than those risk-averse investors here.
These investor types are usually newer investors and have not yet invested in many risky investments. Having saved money in bank account savings or fixed deposits, they consider investing in stocks. Thus, they expect more in return than risk-tolerant investors. So, the premium is significantly higher with such investor types.
The second component is that of Investment Type. This is the kind of investment that an investor is ready to invest it. Should those investments be the risky type, the return expected will naturally be significantly more than those lesser risky investments. So, the premium will also be more than those less risky investments.
Two other components that need considering when calculating the formula are also worth paying close attention to.
One of these is the Required Market Risk Premium. This is the difference between the minimum rate expected by investors in their investments and the risk-free rate.
The other is the Historical Market Risk Premium. This is the difference between a particular markets historical rate and the risk-free rate.
The Limitations of Market Risk Premium Formula
The concept of this formula is referred to as an expectancy model. Thus, this means it cannot be accurate most of the time.
For this reason, there are several limitations around using it, including:
- In this formula, computation depends on investors. Therefore, meaning it’s not accurate and can produce too many variables, with too little reliance on proper calculations.
- When using this formula, historical figures are considered. This assumes the future will resemble the past. Yet, as in most instances, this may not be the case.
- The inflation rate is not considered with this formula. So, the real risk premium’s a much better concept than the market premium.
In concluding, there’ll always be risks with any type of investment. But the more you can work against those risks, the better off you place yourself financially