How to Estimate the Market Risk Premium
There are two sides to most any investment: risk and return. In general, the more risk one is willing to take, the higher the potential for profit (or loss). One way investors measure investment return is by looking at a metric called the market risk premium. Treasury bills represent a security with virtually no risk, andas such they are considered risk free. Any amount over the risk free rate is considered the market risk premium. That is, if the risk free rate (current rate on Treasury bonds) is 4 percent, then any amount over 4 percent is considered the market risk premium.
Other People Are Reading
Instructions
-
-
1
Determine which security to use as a proxy for the risk free rate of return in the market. Most investors believe U.S. Treasury Bonds are risk free as they are backed by the full faith and credit of the U.S. Government.
-
2
Look up the current yield on the 10-year U.S. Treasury bond (see Resources for a link). Let's say the current yield on a 10-year U.S. Treasury bond is 5 percent. This is your baseline for comparison.
-
-
3
Determine the expected return of the market. It is general knowledge that the average market return over the past 100 years is about12 percent. The University of Michigan calculated historical returns from 1963 to 1993 as 11.83 percent.
-
4
Estimate the Market Risk Premium. Subtract the risk free rate from the market risk premium. In this example the calculation is: 12 percent - 5 percent = 7 percent.
-
1
References
Resources
- Photo Credit Stock Market image by Paul Heasman from Fotolia.com
