The market risk premium is the rate of return of the market for investments that is in excess of the risk-free rate of return. This rate is important for investors because it tells them how much they gain by investing in a risky asset as opposed to a risk-free asset.
Virtually all investments have some level of risk. Risk is often measured in terms of the volatility of the return of an asset. The greater the potential level of increase and decrease in a stock price, for example, the greater its volatility and the higher its risk. Investors tolerate this risk because of the potential for high returns on the upward side of the volatility swings. For fixed-income securities, such as bonds, the risk involved is not from volatility, because the rate of return is fixed. The risk instead comes from the possibility that the issuer of the bond will default on its obligation to repay the debt, leaving the bond holder with a worthless asset.
The risk-free rate is the rate of return you can earn without any risk of losing your investment. For example, if you put your money into a bank savings account, you can be virtually guaranteed you will receive the stated interest rate without any real risk of losing that money. At the same time, the typical bank interest rate is significantly lower than the rate of return of other investments. For the purpose of calculating the market risk premium, U.S. Treasury bonds, which generally have a higher rate of return than bank interest rates, are used as the risk-free rate.
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Market Rate of Return
The market rate of return is the expected rate of return on a market portfolio. A market portfolio is a portfolio that represents the market as a whole. If such a portfolio is expected to be worth 10 percent more at the end of the relevant period than at the beginning, the market rate of return is 10 percent.
Market Risk Premium
To calculate the market risk premium, simply subtract the risk-free rate from the market rate of return. For example, if the risk-free rate is 4 percent and the market rate of return is 10 percent, the market risk premium is 6 percent. This 6 percent rate of return is an investor's reward for tolerating the risk of the market relative to a risk-free investment.