When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Market Risk Premium: Definition, Calculation, Use, and Examples
When it comes to investing, understanding the balance between risk and reward is essential. A central academic concept in this area is the market risk premium, one of the core principles used in the Capital Asset Pricing Model (CAPM).
QUOTE
Successful investing is about managing risk, not avoiding it.
Big Ideas
- The market risk premium is the additional returns beyond the risk-free rate, typically measured by the 10-year government bond for a given country.
- Market risk refers to both systemic and nonsystemic shocks that can alter potential investment returns.
- There are many methods to calculate the risk-free rate. In recent times, a NYU professor (Aswath Damodaran) has created a more integrated formula.
DEFINITION
Market risk premium (MRP) is the difference between the risk-free rate and the expected return.
The risk-free rate is basically the rate of return gained from long-term bonds issued by the government - the safest possible investment asset because it is backed by the power of the state.
NOTE: In reality, returns from government bonds are not risk-free. At the time of writing (July 2024), the UK 10-year government bond rate is 4.2%, the highest it has been since the 2008 financial crisis, having been close to 0% in 2020. A higher rate means a higher return is being commanded by investors to compensate for more risk.
NOTE: In reality, returns from government bonds are not risk-free. At the time of writing (July 2024), the UK 10-year government bond rate is 4.2%, the highest it has been since the 2008 financial crisis, having been close to 0% in 2020. A higher rate means a higher return is being commanded by investors to compensate for more risk.
Source: Trading EconomicsDepending on risk tolerance, investors will take on a riskier portfolio of assets compared to what they can get from a theoretically risk-free asset, such as government bonds.
The term market risk premium (MRP) is often used interchangeably with the equity risk premium (ERP) because stocks make up such a significant part of modern portfolios. Many market risk premium methodologies will focus only on equities as a benchmark.
Technically, however, market risk premium relates to all market assets (corporate bonds, commodities, niche investments, etc) while equity risk premium is used specifically for stocks.
The formula for market risk premium is very simple - it is merely the expected market return minus the risk-free rate. The expected return is generated by taking historical returns for a specific market index and projecting them into the future.
Technically, however, market risk premium relates to all market assets (corporate bonds, commodities, niche investments, etc) while equity risk premium is used specifically for stocks.
The formula for market risk premium is very simple - it is merely the expected market return minus the risk-free rate. The expected return is generated by taking historical returns for a specific market index and projecting them into the future.
FORMULA
MARKET RISK PREMIUM (MRP) = EXPECTED MARKET RETURNS (RM) - RISK FREE RATE (RF)
The risk-free rate is also easily obtained. You can just check the rate for government bonds, which are used as a proxy for a theoretically zero-risk investment. Typically, the S&P 500 is used as a benchmark for the expected market return, as this is where most trading takes place. UK investors might use the FTSE 100 or FTSE 250 indices to calculate expected market return.
Examples of MRP
Let’s say the FTSE 100 has generated 8% over the past 10 years, while the yield on 10-year UK government bonds (gilts) is 4.2%. The market risk premium is simply the expected market returns (8%) minus the risk-free rate (4.2%). So the market risk premium is 3.8%.
For the US market, the S&P 500 might have generated 9% over the past 10 years, and the 10-year US Treasury Bond rate could be 5%. Using the same formula, the market rate risk would be 4%, by subtracting the expected market return (9%) from the risk-free rate (5%).
This method calculates the market risk premium based on the historical average returns of the market minus the risk-free rate. It assumes that past performance can provide a reasonable estimate for future expectations. There are other methods too, that we will discuss below.
For the US market, the S&P 500 might have generated 9% over the past 10 years, and the 10-year US Treasury Bond rate could be 5%. Using the same formula, the market rate risk would be 4%, by subtracting the expected market return (9%) from the risk-free rate (5%).
This method calculates the market risk premium based on the historical average returns of the market minus the risk-free rate. It assumes that past performance can provide a reasonable estimate for future expectations. There are other methods too, that we will discuss below.
Market risk usually refers to the chance that there will be systemic shocks that affect the entire market. This can include a recession, a nuclear meltdown, a war, etc. Market risk is reduced by the essential investment concept of diversification.
Systematic risk (risk inherent to the entire market and hence a more specific way to say market risk) still affects all investments to some extent, but having a diversified portfolio that includes assets like rental properties and commodities can help generate revenue even during challenging economic times.
Yet there are also unsystematic market risks that are more easily hedged. These are the ones that market risk methodologies attempt to predict and manage. Unsystematic market risk include:
Systematic risk (risk inherent to the entire market and hence a more specific way to say market risk) still affects all investments to some extent, but having a diversified portfolio that includes assets like rental properties and commodities can help generate revenue even during challenging economic times.
Yet there are also unsystematic market risks that are more easily hedged. These are the ones that market risk methodologies attempt to predict and manage. Unsystematic market risk include:
- Interest Rate Risk - Refers to the potential for investment losses due to changes in interest rates. It affects companies with significant borrowing or lending activities. Examples: Increased interest expenses on debt, and reduced earnings for financial institutions.
- Foreign Exchange Risk - Arises from changes in currency exchange rates. Impacts companies engaged in international trade or with foreign investments. Examples: Fluctuations in profits due to currency value changes, and hedging costs.
- Commodity Price Risk - Involves the risk of price changes in raw materials and commodities. Affects companies reliant on commodities for production or as part of their products. Examples: Increased production costs, and volatility in profits for commodity producers.
- Equity Price Risk - Relates to changes in stock prices affecting a company’s market value. Influences companies with significant equity holdings or stock-based compensation plans. Examples: Decreased asset values, impact on investor confidence and funding ability.
A multitude of factors can affect the market risk premium. The main three drivers are outlined below.
1. Economic conditions and market volatility
Economic conditions significantly impact the market risk premium. During periods of economic growth, companies typically perform well, leading to higher stock prices and reduced risk premiums. During recessions or economic downturns, uncertainty and risk increase, causing investors to demand higher returns to compensate for the additional risk.
Source: Wall Street MojoMarket volatility also plays a crucial role. Higher volatility indicates greater risk, which leads to a higher market risk premium. Events such as geopolitical tensions, natural disasters, and financial crises can amplify market volatility, further influencing the risk premium.
Stable economic conditions and low volatility generally result in a lower market risk premium as investors feel more secure about future returns.
Stable economic conditions and low volatility generally result in a lower market risk premium as investors feel more secure about future returns.
2. Investor risk aversion
Investor risk aversion is a key factor in determining the market risk premium. When investors are more risk-averse, they require a higher return to invest in risky assets, leading to a higher market risk premium.
Risk aversion can be influenced by various factors, including recent market performance, economic outlook, and individual investor experiences. During times of financial uncertainty or after significant market losses, investor risk aversion tends to increase.
This shift causes a demand for safer investments, such as government bonds, and a higher premium for taking on equity risk. Conversely, when investors are more confident, their risk aversion decreases, leading to a lower market risk premium.
Risk aversion can be influenced by various factors, including recent market performance, economic outlook, and individual investor experiences. During times of financial uncertainty or after significant market losses, investor risk aversion tends to increase.
This shift causes a demand for safer investments, such as government bonds, and a higher premium for taking on equity risk. Conversely, when investors are more confident, their risk aversion decreases, leading to a lower market risk premium.
3. Interest rate environment
The interest rate environment directly affects the market risk premium. When interest rates are low, the return on risk-free investments, like government bonds, decreases. Investors then seek higher returns from equities to justify the additional risk, leading to a higher market risk premium.
Conversely, when interest rates rise, the return on risk-free investments becomes more attractive, and the market risk premium typically decreases. Central banks influence interest rates through monetary policy, affecting investor behaviour and the overall risk premium.
Inflation expectations, which are closely tied to interest rates, can also impact the market risk premium as they influence the real returns investors expect from their investments.
Conversely, when interest rates rise, the return on risk-free investments becomes more attractive, and the market risk premium typically decreases. Central banks influence interest rates through monetary policy, affecting investor behaviour and the overall risk premium.
Inflation expectations, which are closely tied to interest rates, can also impact the market risk premium as they influence the real returns investors expect from their investments.
There are three main methods for estimating the market risk premium, each based on different ways of calculating the expected market return: the historical average model, the survey method, and the dividend discount model (DDM). Additionally, a modern approach by prominent NYU finance professor Aswath Damodaran is gaining popularity and is detailed in an online research paper.
1. Historical average method
The historical average method calculates the market risk premium by analysing the difference between historical returns on stocks and risk-free assets, typically government bonds. This method involves gathering long-term data on stock market returns and comparing it with long-term government bond yields.
The difference between these two averages represents the historical market risk premium. This approach assumes that past performance can provide insights into future expectations, although it may not account for changing economic conditions.
The difference between these two averages represents the historical market risk premium. This approach assumes that past performance can provide insights into future expectations, although it may not account for changing economic conditions.
2. Survey method
The survey method involves collecting estimates from financial professionals and investors about their expectations for future market returns and risk-free rates. By averaging these expectations, the market risk premium can be inferred.
Surveys can include responses from a variety of market participants, such as fund managers, analysts, and academics. This method relies on the collective wisdom of experienced individuals but may be subject to biases and differing interpretations of market conditions.
Surveys can include responses from a variety of market participants, such as fund managers, analysts, and academics. This method relies on the collective wisdom of experienced individuals but may be subject to biases and differing interpretations of market conditions.
3. Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) estimates the market risk premium by forecasting future dividends of a broad market index and discounting them back to their present value using a required rate of return. This model involves estimating the expected growth rate of dividends and calculating the present value of these expected dividends.
The difference between the required rate of return and the risk-free rate gives the market risk premium. The DDM incorporates future growth expectations but requires accurate dividend forecasts and growth rate assumptions, which can be challenging to predict.
The difference between the required rate of return and the risk-free rate gives the market risk premium. The DDM incorporates future growth expectations but requires accurate dividend forecasts and growth rate assumptions, which can be challenging to predict.
Aswath Damodaran has been highly critical of how market risk is calculated, indicating that it relies on many assumptions and basically just projects past returns forward into the next year. He has created a much more integrated formula that includes many different aspects for a more well-rounded answer.
SIMPLIFIED FORMULA
ERP = EXPECTED DIVIDEND YIELD + EXPECTED LONG TERM GROWTH RATE - RISK FREE RATE
This formula essentially takes the expected future cash flows (dividends or earnings), adjusts for growth, and then subtracts the risk-free rate to derive the implied equity risk premium. Dividend yield can be calculated by dividing next year's dividend by the current stock price.
Here are the parts that go into the Damodaran approach:
Here are the parts that go into the Damodaran approach:
Damodaran starts by calculating the historical ERP, which is the average return on stocks minus the average return on risk-free securities over a long period. This historical perspective provides a baseline but is not solely relied upon due to changing market dynamics.
The implied ERP is a forward-looking measure derived from the current market prices and expected future cash flows. Damodaran uses the Dividend Discount Model (DDM) to estimate the expected return on stocks by considering the current market price, expected dividends, and growth rates.
The difference between this expected return and the current risk-free rate gives the implied ERP. This method adjusts for current market conditions and investor expectations.
The difference between this expected return and the current risk-free rate gives the implied ERP. This method adjusts for current market conditions and investor expectations.
Adjustments for current conditions
Damodaran's approach also involves making adjustments based on current economic conditions, such as interest rates and corporate profitability. By incorporating these factors, his method provides a more dynamic and realistic estimate of the ERP, reflecting the contemporary market environment.
Weighted Average
Finally, Damodaran often combines the historical and implied premiums to arrive at a weighted average ERP. This balanced approach leverages the stability of historical data and the relevance of current market expectations, offering a robust estimate of the equity risk premium. This method is widely used and respected in financial analysis and valuation.
The market risk premium will be different depending on the market in question as well as the methodology used.
The table below is from Aswath Damodaran’s newer model - it makes certain assumptions that might not be aligned with other market risk approaches. The table has the first 12 entries and also includes the UK and USA. It is current as of January 2024.
The table below is from Aswath Damodaran’s newer model - it makes certain assumptions that might not be aligned with other market risk approaches. The table has the first 12 entries and also includes the UK and USA. It is current as of January 2024.
Country | Adj. Default Spread | Equity Risk Premium | Country Risk Premium | Corporate Tax Rate | Moody's rating | Sovereign CDS Spread |
Abu Dhabi | 0.54% | 5.32% | 0.72% | 15.00% | Aa2 | 0.75% |
Albania | 4.90% | 11.18% | 6.58% | 15.00% | B1 | NA |
Algeria | 4.90% | 11.18% | 6.58% | 26.00% | NR | 1.70% |
Andorra (Principality of) | 2.07% | 7.38% | 2.78% | 18.98% | Baa2 | NA |
Angola | 7.08% | 14.11% | 9.51% | 25.00% | B3 | 7.82% |
Anguilla | 10.54% | 18.75% | 18.75% | 27.25% | NR | NA |
Antigua & Barbuda | 10.54% | 18.75% | 18.75% | 27.25% | NR | NA |
Argentina | 13.07% | 22.15% | 17.55% | 35.00% | Ca | 46.19% |
Armenia | 3.92% | 9.86% | 5.26% | 18.00% | Ba3 | NA |
Aruba | 2.07% | 7.38% | 2.78% | 25.00% | Baa2 | NA |
Australia | 0.00% | 4.60% | 0.00% | 30.00% | Aaa | 0.26% |
Austria | 0.44% | 5.18% | 0.58% | 24.00% | Aa1 | 0.27% |
United Kingdom | 0.65% | 5.48% | 0.88% | 25.00% | Aa3 | 0.51% |
United States | 0.00% | 4.60% | 0.00% | 25.00% | Aaa | 0.58% |
The table also includes adjusted default spread, country risk premium, corporate tax rate, Moody's bond rating, and the CDS spread for a more complete picture of risk vs rewards. Broadly speaking, Damodaran focused on three factors for these ratings - political, legal, and economic risk.
Another popular market risk premium research paper is that of Professor Pablo Fernandez of the IESE business school. It took a survey-based approach and obtained significant answers from 80 countries.
This methodology assigned a market risk premium of 6.0% in the UK in 2023 and 5.7% in the USA. It runs yearly and includes the market risk premiums from all previous years since the survey started. It is commonly cited among industry professionals.
Another popular market risk premium research paper is that of Professor Pablo Fernandez of the IESE business school. It took a survey-based approach and obtained significant answers from 80 countries.
This methodology assigned a market risk premium of 6.0% in the UK in 2023 and 5.7% in the USA. It runs yearly and includes the market risk premiums from all previous years since the survey started. It is commonly cited among industry professionals.
In this article, we have covered the concept of market risk. While there are many methodologies, the essence is extremely simple. It is merely the difference between the expected return of the asset (usually a stock) and a risk-free asset (usually a government treasury bond).
All it does is show what the asset returns historically versus a risk-free asset - it does not indicate whether or not you should invest. Moreover, it does not account for volatility, which needs to be investigated through the CAPM model, asset beta, and Sharpe ratio.
Finally, Aswath Damodaran’s newer model is proving to be very popular industry-wide and could set a new standard in how market risk premiums are calculated.
All it does is show what the asset returns historically versus a risk-free asset - it does not indicate whether or not you should invest. Moreover, it does not account for volatility, which needs to be investigated through the CAPM model, asset beta, and Sharpe ratio.
Finally, Aswath Damodaran’s newer model is proving to be very popular industry-wide and could set a new standard in how market risk premiums are calculated.
Q: Is the market risk premium guaranteed?
No, the market risk premium is not guaranteed. It is based on future expectations and historical data, and actual returns can vary significantly from these expected returns due to market volatility and economic changes.
Q: What is the equity risk premium?
The equity risk premium (ERP) is the additional return expected from investing in stocks over a risk-free asset, such as government bonds, to compensate for the higher level of risk associated with stocks.
Q: Is the market risk premium the same as the beta?
No, the market risk premium is the extra return expected from the overall market compared to the risk-free rate, while beta measures an individual stock’s volatility relative to the entire market.
Q: Is a low-market risk premium good?
A low market risk premium indicates lower expected returns from the stock market compared to risk-free assets, which can be less attractive to investors seeking higher returns and willing to accept more risk.
Q: Is high-risk premium good or bad?
A high-risk premium indicates higher expected returns from the stock market but also suggests a higher perceived risk. It can be good for risk-tolerant investors seeking higher returns but may deter conservative investors.
Q: What is the target market risk premium?
There is no universally accepted target market risk premium; it varies based on economic conditions, investor expectations, and historical data. Typically, it ranges from 3% to 7%, depending on market conditions.
Q: What if the market risk premium is negative?
A negative market risk premium means investors expect lower returns from stocks compared to risk-free assets, indicating extreme risk aversion or a highly negative outlook on the stock market’s future performance.
- Capital Asset Pricing Model (CAPM): A model used to determine the expected return on an investment, based on its risk relative to the market as a whole. It incorporates the risk-free rate, the market risk premium, and the asset’s beta to estimate the return an investor should expect.
- Volatility: A measure of how much the price of an asset fluctuates over time.
- Credit Default Swap (CDS): A financial derivative that acts as insurance against the default of a borrower. The CDS spread is often used as a measure of credit risk, indicating how risky investors perceive a particular company or country’s debt to be.
- Moody’s Bond Rating: A credit rating assigned by Moody’s Investors Service to measure the creditworthiness of a bond issuer. Higher-rated bonds (e.g., AAA) indicate lower risk, while lower-rated bonds (e.g., B or C) suggest higher risk and the need for a greater market risk premium.
- Country Risk Premium (CRP): An additional return required by investors to compensate for the risks of investing in a particular country, including political instability, economic uncertainty, and currency fluctuations.
- Default Spread: The difference in yields between government bonds and corporate bonds, used to measure the risk premium associated with corporate debt relative to a risk-free asset.
- Sharpe Ratio: A metric used to assess the risk-adjusted return of an investment. It compares the return of the investment to the risk (volatility) taken to achieve that return. A higher Sharpe ratio indicates better risk-adjusted performance.
- Beta: A measure of an asset's volatility in relation to the overall market.
