How to Calculate a Market Risk Premium

The ideal investment is no risk and all gain. However, finding this elusive investment is akin to searching for a pot of gold. Most investment managers settle for achieving gains above the risk free rate. Market risk premium is the difference between the risk free rate and expected returns on the market. Investors use it as a way to price assets. In fact, it represents the slope of the most popular capital asset pricing model (for all the math nerds). The calculation is easy; the challenge is determining a proxy or an estimation for the different variables within the formula.

Difficulty: Moderately Easy

Instructions

1. Review the market risk premium formula. Market risk premium = expected market return - risk free rate.

2. Determine the "risk free" rate of return. Treasuries are considered to be risk free as they are backed by the "full faith and credit" of the U.S. government. For this reason, we can use them as a proxy for the risk free rate.

3. Look up the 10 year treasury yield. The Federal Reserve Bank (FRB) publishes updated treasury rates once a month. The current rate on a 10 year treasury is 3.88 percent.

4. Determine the expected return of the market. According to Ibbotson Associates, the S&P has returned an average of 10.3 percent a year, compounded, since 1926 (CNN, 2008). We will use this as a proxy for expected return of the market.

5. Determine the market risk premium. The market risk premium equals the average expected return from the market (10.3 percent) minus the risk free rate (3.88 percent). The risk premium = 6.42 percent.

References

• Investopedia: Market Risk Premium
• Journal Article: Estimating Equity Risk Premiums
• CNN: Don't Expect Another Bull Market

Resources

• Journal Article: Market Risk Premium - Required, Historical and Expected
• The Cost of Equity
• FRB: Selected Interest Rates