How to Calculate Market Risk

Investing can be a scary proposition to a novice when she's starting out. But there are some simple calculations than can help to determine the risk of making investments. According to Investopedia, the market risk premium equals the expected return minus the risk-free rate of return. The expected rate of return is set at 10.3 percent compounded annually, since 1926. The risk-free rate is the rate in theory that an investor could expect to earn if the investment had no risk.

Instructions

1. Obtain the 10-year yield for treasury, according to the Federal Reserve Bank. This number is updated each month. As of November 2010, the 10-year treasury yield is 2.54 percent.

2. Locate the expected return rate. According to Ibbotson Associates, the Standard & Poor's 500 average compounded expected rate of return is 10.3 percent annually.

3. Calculate the market risk premium using the 10-year yield treasury and the expected return rate. Recall that the formula for the calculation is the expected rate of return minus the risk-free rate. The calculation is as follows: 10.3 - 2.54 = 7.76. This means that the current market risk premium as of November 2010 is 7.76 percent.

4. Understand what a market risk premium of 7.76 percent really means in terms of making an investment. Essentially, a market risk premium at this rate means that this is the estimated difference that the investor can expect if she chooses to hold a riskier asset, such as an equity, instead of holding a treasury asset. Whether an additional 7.76 percent return is worth the risk is a question that only the investor can decide, on the basis of factors he or she deems important.

Tips & Warnings

• The market risk premium is also equal to the slope of the security market line, which represents the connection between asset risk and required return rate. Consequently, as the average investor's aversion to risk increases, so does the risk premium and the required return rate.

References

• University of Cincinnati College of Law: Securities Lawyer's Deskbook
• Investopedia: Market Risk Premium
• Investopedia: Risk-Free Rate of Return
• CNN Money: Don't Expect Another Bull Market
• Stern School of Business: Estimating Equity Risk Premiums

Resources

• Federal Reserve Bank: Statistical Release of Interest Rates
• Investopedia: Expected Return
• ValuePro: Cost of Equity
• Georgia State University: Risk and Return