Market risk premium

Definition

The market risk premium is the additional return expected by investors for taking on the higher risk of investing in the stock market over a risk-free asset. It is a key component in determining the cost of equity using the Capital Asset Pricing Model (CAPM).

5 Must Know Facts For Your Next Test

1. The market risk premium is calculated as the difference between the expected return on the market portfolio and the risk-free rate.
2. It reflects investors' expectations about future returns and their tolerance for risk.
3. A higher market risk premium indicates greater compensation required by investors for taking on additional risk.
4. The value of the market risk premium can vary over time due to changes in economic conditions and investor sentiment.
5. In CAPM, it helps determine an individual stock's expected return by multiplying it with the stock's beta.

Review Questions

• What does the market risk premium represent in financial terms?
• How is the market risk premium calculated?
• Why is understanding the market risk premium important for determining an asset's expected return?

Related terms

Beta:

A measure of a stock's volatility in relation to the overall market.

Risk-Free Rate:

The theoretical return of an investment with zero risk, typically represented by government bonds.

Expected Return:

The anticipated profit or loss from an investment based on historical data or analytical models.