Definition of Market Risk Premium?

The difference calculated between the expected return on the market portfolio and the risk-free rate is called the market risk premium, it is equal to SML and CAPM (Now SML here stands for Security Market Line and CPM stand for Capital Asset Pricing Model). CAPM is a very important part of the portfolio theory and discounted cash flow as it measures the return on investments which is the most important part for an investor of Market Risk Premium. In simple words, you can say that it is an additional return expected to be received by the investor despite holding the risky market portfolio of risk-free assets. 

Concept

There are basically 3 factors here

• The Required Market Risk Premium-

This means that the minimum amount an investor should accept. They will not think od investing if the rate of return is lesser than the required rate of return, this is also called as hurle rate of return

• Historical Market Risk Premium – 

This is calculated by the returns an investor gets from his past investments of the instrument. In this premium, all the investors get the same amount of result coz the calculation is purely on past performances.

• Expected market risk premium – 

This solely depends on the investor’s return expectation.

In case one that is required market risk premium – Every invertor will expect a different market risk premium. The investor has to calculate the cost of equity as it acquires the consideration of the investment.

In case two historical market risk premium  – the result of a return will only differ on what instrument the analyst has used. Mostly S&P 500 is used as a benchmark to calculate.

Market Risk Premium Formula & Its calculation done as follows

The formula is Market Risk Premium = Expected Rate of Return – Risk-Free Rate