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Market Risk Premium

Reviewed by Vineeth | Updated on Sep 30, 2020

Catalogue

Introduction

The market risk premium is defined as the difference between the expected rate of returns on a market portfolio and the rate, which is considered risk-free. Investors are needed to compensate for the risk and the cost of opportunity. The rate that is risk-free is a theoretical interest that is to be paid by an investment at zero risks, and the United States yields that are long-term have typically made use as a proxy for the interest rate that is risk-free as they are of lower risk of default.

Treasuries have generally had comparatively lower yields due to the result of this imagined dependence. The returns on the equity markets are on the basis of the expected returns on a proper benchmark index like the Standard and Poor 500 index.

Understanding Market Risk Premium

The market risk premium is obtained by the slope of the SML (security market line). The CAPM is used to measure the required rate of return on equity-linked investments. It is critical in the modern theory of portfolio.

The real equity returns vary with the operational performance of businesses that are underlying. Hence, the pricing of the markets for such securities reflects it. The past rates of returns have varied as the economy gets old and goes through cycles, but the traditional knowledge has typically calculated the long-term potential of around 8% annually.

Investors ask for a premium on the investments on the equity instruments as compared to lower risk alternatives as their investment is more subject uncertainty which ultimately paves the way to the equity premium risk.

  1. The market risk premium explains the relation between treasury bonds and equity market portfolio.
  2. The risk premium shows the required returns, expected returns, and historical returns.
  3. Historical market risk is the same for all investors while the required and expected returns vary across investors, depending on the investing styles and risk tolerance.

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