The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate. The slope of security’s medium line (SML), which represents the capital asset pricing model (CAPM), explains how much investors need to earn not to lose the asset’s value over time. If you’re considering buying stocks or bonds, you can use this measure as an input for your discounted cash flow valuation models.
Calculation and Application
It is easy to calculate the market risk premium for a company. Here is how we can do it:
You can calculate the market risk premium by subtracting the risk-free rate from the expected market return while providing the quantitative measure of extra return that the participants in the market demand. After calculating the equity risk premium, you can use the market risk premium in necessary calculations like CAPM.
From 1926 to 2014, the S&P 500 exhibited an annual return rate of 10.5% greater than that of Treasury bills which compounded at 5%. Therefore, there is a market risk premium associated with stocks in today’s economy worth five percentage points more than what you would expect without those risks involved!
You can calculate the required rate of return for an individual asset by multiplying the market risk with the asset’s beta coefficient and adding that amount back into your evaluation. The required rate of return is often used as a discount rate in discounted cash flow, which determines how much money you would need at current rates if there were no interest or inflation on top of it during our time frame today!
