The extra or additional return that an investor receives or he expects to receive from a market risk portfolio is called Mark Risk Premium.
CAPM which means the Capital Asset Pricing Model is used by analysts and investors to calculate the rate of return that can be accepted from a particular investment. Market Risk Premium is a part of the same CAPM. In CAPM there is a calculation of Risk also called volatility of returns and reward known as the rate of return. Any investor will always prefer to invest where he can get a rate of return more than the volatility of returns
There 3 concepts of how to Determine The Market Risk Premium
- Required Market Risk Premium
This means the return amount that investors should accept. If the rate of return of investment is lower than the required rate of return then the investment should not be made by an investor, this is also known as the hurdle rate of return.
- History Market Risk Premium
A measure of return from the last investment used to determine the premium of future investment. This type of premium that is History Market Risk Premium will give the same return to all investors because the calculation is completed based on the past performance of that investment.
- Expected Market Risk Premium
This is purely based on the expectation that an investor has on the investment.
Required Market Risk Premium and Expected Market Risk Premium are the Risks that completely depends on the investor to investor. Calculating these two risk premiums the investor should consider the cost that was taken while acquiring investment.
In Historical Market Risk Premium, the return depends on the analyst, that is what instrument he uses to calculate. Commonly S&P 500 is used by them as a benchmark for the calculation.
Normally there is a government bond that is used to see the risk-free rate of return as it may be nearly no risk.
Market Risk Premium = Expected Rate of Return – Risk-Free Rate
Market Risk Premium Use
As you know now that market risk premium is a part of CAPM, that means the return of an asset plus premium into the beta of the asset. Beta here means the measure of how risky the investment in the market. The premium is adjusted as per the risk of the investment. An investment or asset that has zero risks that mean zero betas will have market risk premium canceled. But if you see high-risk investment or asset that has 0.8 betas will have nearly full premium, if you take 1.5 betas then your asset will have 150% of volatile more than market.
A now you know that the relationship between risk and reward is a very important part of market risk premiums. For example, if the security returns are 15% on-time period then the volatility returns are zero. On the other hand, if some security gives you 25%, 35% and 10% in three different periods then this will be higher volatility of return. This will also be known as “risker” even if you are getting a higher return on average. Here the risk-adjustment returns are applicable.